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Use debt mutual funds to manage volatility in Investment

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There's a lot happening in the economy right now that can directly impact your fixed income portfolio. After the US Federal Reserve gave the signal that the stimulus measures might soon be squeezed, foreign investors have started fleeing debt investments, offloading bonds and driving up bond yields. It also means that bond prices are taking a knock.

With the Reserve Bank of India (RBI) deciding not to cut repo rates, despite market expectation to the contrary, investors who positioned themselves for a rate cut by investing in long- term debt funds or gilt funds have been stranded. The outlook for an interest rate cut is not as clear now, as rupee depreciation could drive up inflation, which could further curb RBI's ability to cut rates.

Hence, re- look at your investing strategy of parking funds in long term bond funds and re- focus on the basics of debt investing.

For starters, if you are looking for a safe place to park your money now, there's nothing as good as bank fixed deposits (FDs). Interest rates have held up well from banks as they are offering high rates to garner more deposits. Similarly, it is advisable to lock into some short- term income funds and dynamic bond funds to take advantage of the fact that interest rates might not go down in a hurry.

Since debt still looks safer under these circumstances, here are some debt products you can consider. However, asset allocation should be in sync with your goals.

Debt mutual funds

Further, long- term debt funds could take a knock on net asset values as yields rise. That's because the price of bond and yields are inversely related. Therefore, investors are better off sticking to short- term bond funds which invest in debt that matures in a short duration.

With the continuously depreciating rupee and the crashing markets, investors can also look at dynamic bond funds. Reason: These take a call on the duration of the funds depending on market conditions. In this case, the fund manager has the flexibility to switch between the underlying debt instruments depending on the outlook on interest rates.

One should keep a horizon of at least one year while investing in dynamic bond funds. Whereas, if your investment horizon is about six months, you should look at liquid funds, which invest in short term debt instruments with maturities of less than one year.

When interest rates were low with high bond prices, dynamic bond funds have returned as high as 14 to 18 per cent. Taking the current scenario into consideration, investing in short- term funds makes more sense than investing in a fixed deposit, if your horizon is for one- two years

For investors in the higher tax bracket, credit opportunity bond funds, which are accrual products. These invest into high- yield corporate papers and give better yield than income funds. They invest in papers that have lower ratings than ' AAA', such as ' AA' or ' AA-', with a view to enhancing yields.

Tax- free bonds

There is no fear of interest rates falling swiftly from these levels. Interest rates will move down, but gradually. Investors should choose funds where there is a chance for capital appreciation.  Tax- free bonds of National Highways Authority of India and Hudco are good investments.

In the case of bank FDs, the interest will be added to your income and you will be taxed according to your income- tax slab. Hence, it is suitable for those in the lowest tax- bracket. Debt funds are better for those in the higher tax- bracket. In case of debt MFs, if you opt for the dividend distribution option, you will be taxed at 20 per cent. If you opt for the growth option and stay invested for more than one year, you will have to pay 20 per cent tax without indexation and 10 per cent tax with indexation. In this case, the tax outgo will work out much less.

Product When to invest Risk Returns Tax profile implication

Bank FD Falling interest rates Low Moderate Taxable capital gains tax Dynamic Falling or rising - Depending Bond Fund these funds are High on period managed actively of holding Income Fund Falling Moderate Same as above Tax Free Bond Falling Low Moderate NA

 

Bank deposits

Since FD rates are fixed with assured returns, one might be tempted to lock into the highest tenure. But the longest tenure need not necessarily offer the highest return. So, investors should choose the tenure and return depending on their need for cash.

Typically, as the tenure increases, the rate comes down because banks don't want to lock into very high rates for a longer tenure. Two to three years is a good time to lock into an FD.

For instance, if a bank is offering a higher rate on a one- year deposit than a two- year one, you could consider investing now. If you want to reinvest after one year, the rates might have moved down.

State Bank of India offers 8.75 per cent on FDs of 5- 10 years. So, if you invest now, you will continue to get 8.75 per cent every year for 10 years.

And, if you start a recurring deposit (RD), you can invest small amounts every month and get the same return. While this looks more attractive than the rates offered on Provident Fund, remember the returns from Provident Fund are tax free, unlike returns from bank FDs.

Kotak Mahindra Bank launched an RD last week. The interest rate is eight per cent for a 5- 10 year deposit. Usually, RD does not look attractive when interest rates are low. We decided to launch this, as interest rates now are reasonably high. However, advise is against locking into deposits for as long as 10 years because interest rate cycles change every two or three years.

Happy Investing!!

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You can write back to us at PrajnaCapital [at] Gmail [dot] Com

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