Is it the right time to invest in debt funds?

When planning to invest in funds, whether equity or debt, there are two questions you must ask yourself:

• What is your risk appetite?
• What is your investment horizon?

The reason being these two questions determine your investment avenue. So, if you are a risk-taker with a long-term horizon (at least 5 years), you can park your money in equity funds.

Conversely, for risk-averse investors with 3-5 years’ investment horizon, debt funds are a safer and better option.

Now, many of you may have heard about the debt funds but don’t really understand what the product is all about. Let’s decode this product further and understand their usefulness. For a starter, debt funds are mutual funds that invest in debt and fixed-income securities, such as corporate bonds, debentures, government securities and commercial papers. These securities guarantee safety of principal and income. However, these two features come at a cost — returns are much lower than that of equities in the long run. Therefore, debt funds suit you if you prefer certainty of income with low or moderate level of risk.

But safe investors will say why not invest in bank fixed deposits instead of debt mutual funds? Well, here’s why you shouldn’t:

• Gains from falling interest rates: The 50-basis point repo rate cut by the RBI recently has led to the lowering of FD rates. Many banks have cut their deposit rates by 25 basis points. So, if you have been parking your investments in bank deposits, your returns from future deposits will take a beating. But, guess what — even falling interests could help you earn more! Unlike bank deposits, debt funds allow you to gain from falling interest rates as bonds prices have an inverse relationship with interest rates.
• Better liquidity: Bank deposits are not tradable and if you wish to withdraw money, you cannot close the fixed deposit in part. Banks charge penalties for premature withdrawal. However, debt funds are more liquid as you can withdraw any amount from your total fund value.
• Low taxation: Debt funds attract almost nil taxes after 3 years while interest earned from bank deposits is taxable. Moreover, the interest earned from bank fixed deposits will be taxed under your maximum tax slab while a debt fund redeemed after 3 years would attract long-term capital gains (LTCG) tax of 20% flat rate with indexation. Thus, if you fall under higher tax bracket, you stand to gain from investing in debt funds even if the rate of returns from debt funds and fixed deposits are the same.

Apart from these parameters, the prevailing economic conditions may also influence your decision to invest in debt funds. Let us review some of the factors that may affect the performance of debt funds in short- to medium-term horizon.

• Falling interest rate regime: The Reserve Bank of India (RBI) has already cut the repo rates by 125 basis points in 2015.  The latest 50 basis points rate cut by the RBI on 29 September 2015 has led to hike in bond prices in India. During a falling interest rate regime, debt funds with longer investment horizon, such as dynamic bond funds, gilt funds and income funds, would gain the most when compared to short-term debt funds.

The table below shows how debt funds fared after the 100 basis points repo rate cut by RBI on 11 October 2008 and compares their performance with equity funds during the October 2008 to October 2012 period. As you can see, the rate of returns from many debt funds has been as good as some of the equity funds in that period.

• Falling global commodity and fuel prices: The falling global commodity and fuel prices would ease inflationary pressures in India which would, in turn, give RBI more room to further bring down interest rates. As bonds prices and interest rates have an inverse relationship, falling interest rates would further increase bond prices, thereby pushing up the value of your investments in debt mutual funds.
• Volatility in global markets: In a globalized world, Indian markets cannot stay totally immune to adverse events in peer markets. The present volatility in global markets, coupled with slowdown in China, has adversely affected the FII inflows into India. An expected Federal Reserve rate hike may further lead to flight of capital from emerging markets, including India. As the reduced FII inflows may hurt returns from your equity funds, you can invest in debt funds if your risk appetite is limited.

To sum it up, in the current economic scenario, if you are a risk-averse investor looking for assured returns, debt mutual funds would provide higher returns from other fixed income options like bank fixed deposits.

(The author of the article is the Managing Director of paisabazar.com)

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