Short-term, long-term debt funds outperform liquid, liquid plus funds
MOST investors have investments in fixed income instruments no matter how much they fancy the potential of high returns in equities. Bank fixed deposits (FDs) are the most popular. But investors stand a better chance of getting higher post-tax returns from debt funds compared with bank FDs.
However, debt schemes are not as popular with retail investors as they are with institutional and corporate investors.
A retail investor in our country typically prefers investing in equity or hybrid funds. For fixed returns, they have an impression that debt funds do not provide returns higher than bank FDs or other small savings schemes such as public provident fund.
Besides perceived returns, there are other complexities involved in debt funds investment. There are at least eight different types of debt funds one can invest in. Choosing the right scheme, and particularly the high-return ones, is not an easy task.
For instance, as of July 9, the five-year average annualised pre-tax return of short-term debt schemes of various AMCs was higher, 7.49 per cent, than the average pre-tax return of 6.43 per cent on medium-term debt schemes (see table).
The risk element varies across debt fund categories.
Every debt fund is exposed to two risks — interest rate risk and credit default risk.
Credit default risk can be easily gauged from a debt fund's portfolio by looking at the credit rating of the instruments invested in.
Liquid funds and liquid plus funds are the right choices for investors who look at debt funds for riskfree fixed income.
These schemes are considered very safe thanks to their short tenures of investments, ranging from 15 days to six months.
Fluctuations in interest rates do not alter yields of these schemes as much as they do to longer tenure debt funds. Short-term debt funds usually invest in debt instruments with residual maturity of between six and 12 months. Medium-term and long-term funds have investments in debt, whose maturities are more than a year.
A drop in interest rates raises the yield of debt investments of these funds and vice-versa. In a rising interest rate scenario, the net asset values (NAVs) of medium-term and long term funds are affected adversely.
But that does not necessarily mean there is no case for investing in them, particularly if your intention is to park a part of your investible surplus in them for three to five years or more.
An analysis of five-year returns reveals (see table) except for short-term gilt funds, other short-term, medium-term and long term debt funds have outperformed liquid and liquid plus funds.
Taxation benefits do not change for different types of debt funds. The tax liability depends on the length of time one holds a debt fund before redeeming it. You could sell a liquid fund after holding it for more than a year and pay a 10 per cent tax with indexation or 20 per cent without indexation.
Inversely, if you held on to a long-term debt fund for less than a year before selling it off, you are liable to add the capital appreciation to your total income and pay the highest tax rate applicable to you.
The world of debt funds seems a tricky one. To average out the risks and benefits from different types of debt funds, investors can also choose to invest equal amounts across each of them.
This will happen, provided your investment time horizon is more than a year.
If your surplus funds are available to be parked for six months or less, then liquid and liquid plus funds are the best bet.
