Here are five reasons why debt funds will give you better returns in the New Year
Illustration: Dominic Xavier/Rediff.com
From the time the government had announced demonetisation on November 8, the market analysts have been talking about debt funds becoming more attractive.
Shankar Iyer wanted to understand this better as he had limited knowledge of equity and debt markets considering his technical engineering background.
He decides to consult his colleague Madhavan, a Chartered Financial Analyst, and advises his company on treasury matters, over a cup of coffee.
Here are the five important points Madhavan told Shankar about debt funds and its outlook in calendar year 2017.
Scenario 1: Should you add debt funds currently and through 2017?
There are two ways to address this topic.
Firstly, the yields on the Government 10-year bonds have fallen from 7.5 per cent in June 2016 to 6.8 per cent in November 2016 and further to 6.45 per cent late December. This sharp fall in yields will mean that most of the capital appreciation in the bond prices may have already played out (fall in yield and capital appreciation are inversely proportional).
However, notwithstanding the hawkishness of the US Fed, the yields in India are likely to go down further with falling inflation.
That still leaves capital gains to be made on government bonds and therefore on debt funds.
Of course, if you do not have any exposure to debt funds, you may look to add them in a phased manner so that you also get the advantage of volatility once US embarks on rapid rate hikes in the next calendar year.
Scenario 2: If you are holding bank FDs, should you shift to debt funds?
This is a slightly more straightforward choice.
Bank FDs are likely to see sharply lower yields in the coming months as banks will cut deposit and lending rates in tandem.
With banks flush with liquidity after the surrender of Rs 500 and Rs 1000 denomination notes, banks will have the leeway to embark on aggressive rate cuts. That means FDs are likely to earn lower rates of interest going ahead.
Even in tax terms, debt funds are surely a better choice compared to bank FDs.
Bank FDs attract the peak rate of tax on interest income. On the other hand, dividends on debt funds are totally tax-free in the hands of the investors.
Also, as rates fall, debt funds will benefit from capital appreciation whereas no such benefit is available on bank FDs.
Investors must look at shifting a reasonable portion of their money from bank FDs into more competitive debt funds.
Scenario 3: What should you prefer; equity funds or debt funds?
That is a slightly tricky question as it is almost tantamount to comparing apples and oranges. At the end of the day it boils down to your financial plan.
Your plan sets a certain allocation for equities and certain allocation for debt. That cannot be changed drastically.
However, within the world of debt exposure, you can look at debt funds more aggressively. With falling interest rates, debt funds will surely benefit within the debt pack.
Leaving aside the choice between debt and equity, there is a very interesting insight for investors in 2017.
Normally, we have a situation where either debt or equity outperforms. But falling interest rates, sufficient liquidity infused by RBI and good corporate performance will mean that both debt and equity may outperform.
Scenario 4: If you are holding on to debt funds, how can you tweak the composition?
Having understood the merits of investing in debt funds, the question is which specific category of debt funds to focus on. Floating rate funds may not be a great idea as rates are likely to head downward.
The choice will, therefore, be between income funds, gilt funds, high yield funds and short term funds. The core of your debt fund portfolio will still be constituted by gilt and income funds.
However, one needs to increasingly look at going slightly down the rating curve in the search for higher yields.
Falling rates will help bring down the yields on gilts and income funds.
Secondly, a mix of short term funds is also advisable. These short term funds typically invest in money market instruments like call money, T-Bills, CP (commercial paper), etc. Yields on these short term instruments are influenced more by liquidity than by inflation and repo rate (the rate at which RBI lends money to the banks) changes.
Over the last few weeks, we have seen the yield curve flattening as yields on the long end have fallen faster. The catch-up could happen in the form of short end yields falling sharply due to excess of liquidity in the system. That will provide opportunities in short term funds too.
The answer is to have a mix of all the three categories with gilt and income forming the core of your debt fund portfolio.
Proposition 5: What about tax efficiency of debt funds?
In fact, debt funds also add a lot of value from the tax perspective. To begin with dividends paid out by debt funds are entirely tax-free in the hands of the investor. That makes it more tax efficient compared to bank FDs where one needs to pay peak rates of tax on interest on FD.
While short term capital gains (up to 3 years) are taxed at peak tax rates, long term capital gains are taxed at just 20 per cent with the added benefit of indexation.
That brings down the effective incidence of tax much lower over the 3 year period. Unlike in case of bank FDs, there is no concept of tax deduction at source (TDS) on debt fund dividends, unless you are an NRI.
As Shankar summarises his discussion with Madhavan, the following pointers emerge
- 2017 could be a good year to prefer debt funds over bank FDs; both in terms of returns and in terms of tax efficiency
- The RBI is likely to follow a dovish rate policy (lowering rates) and that will continue to benefit the debt funds in the form of capital gains
- Within the debt funds category, one needs to spread money across traditional gilt & income funds, short term funds and credit enhanced funds to get the best combination
- Irrespective of the attractiveness or otherwise of debt funds in 2017, Shankar is clear that he cannot compromise his core financial plan in search of short term gains
- At least, Shankar was convinced that the time may have come for investors like him to seriously look beyond the lure of FDs and start looking at debt funds as a serious debt market option
Anil Rego is the founder and CEO of Right Horizons, an investment advisory and wealth management firm that focuses on providing financial solutions that are specific to customer needs.