Time to shift from fixed deposits to debt funds; here’s why

RBI has been increasing repo rates – the rate at which the central bank lends to banks – and reducing system liquidity over the last five months. The increase in the key benchmark rate, after holding it for a long period since May 2020, has led to bond yields rising across maturities. For example, the benchmark 10-year G-Sec yields have risen almost 160 bps to 7.49 per cent over the last two years. 

Accordingly, over the last two years, debt funds have not done well as they saw the prices of their holdings going down. This is because when interest rates rise, bond prices fall, and since debt mutual funds need to mark their NAVs to market daily, with the drop in bond prices NAV also suffer. “Debt funds this calendar year have seen investors pulling out almost Rs 2 lakh crore and the returns were mostly positive between 3-4 per cent annualised,” says Sandeep Bagla, CEO, TRUST Mutual Funds.  

But with the yield-to-maturity of bonds going up, many experts say it is a good time to invest in debt funds. For example, if one has a medium-term horizon (4-6 years), doesn’t mind short-term fluctuations in returns, and is looking at post-tax returns, then a certain class of debt funds, called Target Maturity Funds do score well over fixed deposits. “Target Maturity Funds offer yields (net YTM) in the range of 7-7.25 per cent over the maturity of 4 to 6 years. They predominantly invest in government securities, PSU bonds, and state development loans (SDLs), and the instruments are held till the maturity of the scheme. They are good investment options if one treats them like open-ended Fixed Maturity Plans (FMPs), carrying high-quality bond portfolios and the potential for better post-tax returns. The only caveat is that the investor shouldn’t mind the temporary fluctuations in NAV,” says Alok Aggarwala, Chief Research Officer, Bajaj Capital Ltd.

“We are recommending investments into funds which have roll down or portfolio maturity of 2 years or lesser. It is quite possible that inflation could remain stubborn and yields may remain higher for a longer period of time. At this point, we would advise only 5-10 per cent to longer-term funds, about 25 per cent to liquid/money market funds, and about 65 per cent to short-term funds or BPSU (Banking and PSU) debt funds with roll-down maturity of lower than 2 years,” says Bagla. 

Debt funds also score over fixed deposits because of the tax advantage they offer. “When bond rates are rising faster than bank FD rates investing in bond funds should give a portfolio yield higher than fixed deposits. If an investor would hold his/her investment in mutual funds for more than 3 years, the investor would need to pay tax at long-term capital gains tax with indexation benefit. Hence, the post-tax returns for debt mutual funds could be far higher than post-tax returns of bank FDs as there are no tax benefits for holding 3-year deposits,” says Bagla.

Hence, if one wants to leverage on interest rate movement, it is a good time to invest in debt funds. “For example, in fixed deposits, whereas bank deposits carry a low-interest rate of 5.45-6.10 per cent, certain AAA-rated corporate deposits carry a coupon of around 7 per cent or slightly higher, which, coupled with a lack of interest rate risk, makes them an attractive proposition,” says Aggarwala. Last but not least one needs to pick according to the risk profile, as a higher interest rate comes with higher risks.

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