Reviving debt mutual funds: How market shifts and tax changes can help these MFs make a comeback

Aparna Raj, a 35-year-old IT professional living in Noida, prefers a straightforward approach when it comes to investments. She has a strong preference for the stability and security of fixed deposits (FDs) over risky options like equity or other exotic asset classes. This simple strategy has rewarded her well so far, especially considering the rising interest rates in recent years. With the interest rate cycle projected to start declining, Raj is contemplating whether it’s wise to continue with FDs. She can foresee the reinvestment risk when her FDs mature, and she might have to settle for lower FD rates upon renewal. What will be her next move?

“I have started exploring other options, such as debt funds, to have some exposure to government, state, and corporate bonds to maximise returns from my fixed income portfolio. I invest in FDs because of their simplicity, but the strategy might not give good returns in the future. I need to be vigilant about the changing trend,” says Raj.

Not just Raj; there are many others who share her fondness for FDs. Data shows FDs are nearly nine times larger than debt mutual funds (MFs). According to CareEdge Ratings, as of September 30, 2023, the assets under management (AUM) of open-ended debt MFs amounted to approximately Rs 13 lakh crore, while the base of outstanding term deposits was Rs 115 lakh crore. This gap between the two has only widened in recent years, primarily because of the rise in FD rates and the removal of tax benefits on debt funds.

The situation, however, could undergo a transformation this year. There are expectations that the US Federal Reserve may initiate interest rate cuts, as the inflation rate shows signs of declining. In December 2023, the inflation rate dropped below a 3% annual rate, in line with the US Fed target.

In such a scenario, the question arises if debt funds can be a better option to cash in on the downward trend in interest rates. With 16 different types of Sebi-defined debt funds available, it can be challenging to determine which one is the best investment option. Is it still worth investing in these funds now that their tax advantage has been removed? Here is a lowdown on how to strategise your debt fund investment to maximise returns from the expected decline in interest rates.

High Inflation, High Interest

The past few years have been highlighted by high interest rates. Many developed countries experienced a significant rise in inflation, forcing their central banks to adopt inflation-targeting monetary policies. As a result, interest rates moved up globally. For example, the US Fed has raised policy rates by an unprecedented 550 basis points (bps) since March 2022.

Closer home, the scenario is similar. Since May 2022, the Reserve Bank of India (RBI) has increased the repo rate—the rate at which banks borrow money from the central bank—by 225 bps to combat the high inflation. As the repo rate went up, banks also increased their deposit rates to attract more deposits, thereby reducing liquidity in the system to control high inflation. Consider this: currently, while traditional banks are offering investors a 6-7% annual interest rate on FDs, small finance banks (SFBs) are giving as much as 8-9%. While FDs have been offering high returns, the experience of debt investors was not good in 2022 and 2023, as the interest rate tightening cycle resulted in mark-to-market (MTM) losses in the portfolio of high-duration funds. MTM captures the current market value of a security or portfolio, rather than its book value.

Debt funds primarily focus on investing in fixed-income securities such as government- or corporate bonds and money market instruments. The prices of these securities are directly affected by interest rate changes, as bond prices and interest rates are inversely proportional. When interest rates go up, the prices of existing bonds decline, and MFs need to mark their net asset value (NAV) to the market daily, and hence the MTM losses.

This also resulted in debt fund outflows. From Q1FY20 to Q2FY24, debt MFs have seen outflows in 12 of the 18 quarters, amounting to around Rs 1.31 lakh crore. This has led to a consistent decline in the share of debt MFs in the total AUM of the MF industry—dropping from 53% in March 2020 to 30% in September 2023, according to CareEdge Ratings.

However, muted returns are not the sole reason for this. Debt funds as an asset class have also lost their appeal due to the rising equity market and the removal of tax benefits associated with these funds. Under the new taxation laws, the indexation benefits applicable to long-term capital gains on debt MFs have been removed. Now they are taxed on par with FDs at the marginal rate.

Anticipated Fall

The year 2024 could be a favourable one for the bond market as central banks are expected to lower policy rates. The quantum and timing of rate cuts will vary across countries depending on the state of their respective economies. “As far as India is concerned, we believe that the RBI may consider rate cuts from October 2024 onwards after thoroughly reviewing factors such as the new Union Budget, ongoing inflationary pressures, the global growth-inflation dynamic, and the policy rate environment,” says Dhawal Dalal, CIO-Fixed Income at Edelweiss MF.

This might bring some relief, considering that debt funds have not performed well in the past year. “Indian bonds delivered mid-single-digit returns in 2022 and 2023. In both calendar years, returns from the bond market failed to surpass the average inflation levels in the economy,” says Dalal.

Now that the tightening rate cycle has reached its peak, it appears that we can expect softer rates going ahead as inflation cools and global growth slows. “The RBI expects inflation to decline to 4% by Q2FY25. This could mean that the RBI would maintain status quo on rates in the coming meetings before considering rate cuts in the latter part of H1FY25,” says Rajiv Bajaj, Chairman & MD of BajajCapital, an investment management company.

Impact on Debt Funds

In 2024, the bond market looks promising because of multiple compelling factors. “The outlook for the bond market looks benign amidst robust tax collections, fiscal consolidation plans, and the inclusion of Indian bonds in J.P. Morgan global indices,” says Bajaj. He believes the potential inclusion of Indian bonds in the J.P. Morgan indices could result in a significant inflow of $25-30 billion.

However, the question that arises is which debt funds are the best ones to invest in. According to experts, debt funds that invest in long-term government bonds can be a wise choice, as interest rates are expected to come down gradually over the next few years, reversing the previous upward trend.

“One can consider long-term debt funds and dynamic bond funds with a modified duration of 7-11 years. Interest rates are expected to decline by 75-100 basis points in the next 12-18 months. The expected fall in interest rates can lead to a capital appreciation of 8-10% in addition to the YTM (yield to maturity). Investors can book profits and, on redemption, pay their marginal rate of tax,” says Rajul Kothari, Partner at Capital League, an all-women-led boutique wealth management firm.

Therefore, it is important to check the modified duration of a fund when investing in a long-term debt fund. Modified duration is a useful tool for investors to evaluate the interest rate sensitivity of a bond. It can help investors predict how the bond’s price will be affected by the fluctuations in interest rates. For example, a fund with a modified duration of five years would be expected to experience a 5% gain in price for a 1% fall in interest rates. Similarly, if a fund with a modified duration of eight years and 8% YTM experiences a 50-bps fall in a year, then the estimated return is expected to be near 12% (Average YTM + Modified Duration X Change in Interest Rate).

“We recommend investors consider government securities funds or invest in bond ETFs/bond index funds that primarily focus on long-dated Indian Government Bonds (IGBs)/State Development Loans (SDL) with an average maturity ranging from 10 to 20 years, depending on their individual risk appetite and investment horizon of at least one year. It must be noted that these funds may exhibit higher daily volatility as compared to corporate bond funds. However, they are superior from a risk-adjusted return and total return perspective in 2024, in our view,” says Dalal. SDLs are state government debt issued to meet budgetary expenses and implement development projects.

Investing in medium-term bonds can also be quite appealing. "This segment is also attractive from the perspective of making an additional return from capital appreciation with a lower risk compared to long-duration funds," says Kothari. “Fixed-income investors can consider investing in debt mutual categories such as medium-duration funds, corporate bond funds, and banking & PSU debt funds. Medium-duration funds maintain an average maturity of three to four years, while corporate bond funds invest primarily in the paper issued by the highest-rated entity, and banking & PSU funds prioritise investment in the paper issued by banks and PSUs for a higher level of safety (securities issued by banks and PSUs have higher ratings),” says Bajaj.

However, investors need to keep in mind that for short-term needs, they can park their money in liquid funds, ultra-short-duration funds, and FDs. However, one of the key differences is that FDs have a predetermined rate of return, whereas liquid funds and ultra-short-duration funds invest in money market instruments, and hence their rate of return may vary depending on market conditions.

Importantly, debt MFs carry interest rate risk, which makes them less appealing during periods of rising interest rates. Plus, they have also lost their advantage over FDs as income tax on gains from debt MFs is now taxed at marginal rates similar to FDs, as per the Union Budget 2022-23.

Coming back to Raj, experts advise her to invest based on her risk profile and time horizon. If she is looking for a completely risk-free investment, then FDs are definitely the way to go. However, if she wants to leverage interest rate movements, then including debt funds with longer durations could have a positive impact on her portfolio. Hence, she should choose based on her risk profile, as a higher interest rate is associated with greater risks. Over to Raj now.

 

@teena_kaushal