Is this a good time to buy debt funds?

While an impending rate cut is a good reason to enter debt funds, another is the high valuations in equity markets, reports Joydeep Ghosh.
Illustration: Uttam Ghosh/Rediff.com

Recent reports on the Reserve Bank of India Monetary Policy Committee meeting suggest the apex bank is turning less hawkish.

The decision to hold on to the repo rate was taken by a five-one vote, and this was the first time there wasn't a consensus in the six-member committee.

Both analysts and fund managers believe a rate cut is likely sooner than later.

Says A Balasubramanian, chief executive officer, Birla Sun Life Mutual Fund: "Given the high visibility on low inflation, interest rates should see a reduction of 25 basis points by RBI."

A rate cut to support the sagging fortunes of corporate India should improve yields for debt mutual funds, as interest rates and bond yields move in opposite direction.

This is good news for debt fund investors.

While an impending rate cut is a good reason to enter debt funds, another is the high valuations in equity markets.

While it's tempting to ignore debt instruments when equity markets are hitting new highs regularly, many fund managers and analysts are more than a little worried at the sharp rise in the benchmark indices, especially the mid-and small-cap ones.

And, the valuations are a tad worrying.

The trailing 12-month price-to-earnings (P/E) ratio of the Nifty-50 is 22.4, whereas the five-year average is 18.7.

The current P/E of the Nifty 200 and Nifty 500 are 23.8 and 25.3, respectively, whereas the five-year averages are 19.5 and 20.3, respectively.

Why debt funds? Two reasons.

Returns from small-saving schemes have been falling consistently, and could fall further. And, of course, better post-tax returns.

For the first time in the history of the Public Provident Fund, the rate of interest has gone down below eight per cent (7.9 per cent) for the April-June quarter.

Though the cut of 10 basis points across most small saving scheme instruments wasn't huge, with the RBI and even banks pushing for rate cuts, there are chances that the government will bite the bullet (of lowering rates further) more regularly.

From a one-year perspective, except liquid and ultra-short term schemes, all the other schemes have returned 9.39-14.72 per cent.

One-year fixed deposit (FD) rates, on the other hand, stand at 6 to 7.50 per cent.

"Fixed income schemes have delivered better returns than bank FDs over multiple interest rate cycles. Adjusted for tax, the return is much higher in the long run. Therefore, in a stable to low interest rate regime, for savers through bank deposits, mutual fund fixed income schemes can act as the only big alternative," adds Balasubramanian.

However, a word of caution.

Always remember that debt funds are riskier than fixed income instruments because a fund manager can buy a company's debt paper and then find it has been downgraded.

Debt fund investors would remember that Franklin Templeton Mutual Fund and JPMorgan Mutual Fund investors found themselves in trouble due to downgrading of debt papers of companies which figured prominently in these fund houses' portfolio.

The Securities and Exchange Board of India was forced to step in and tighten rules further for both mutual fund houses and credit rating companies.

What strategy?

However, for investors in debt funds, the strategy being advocated is a combination of duration and accrual funds, with more emphasis on the latter.

Duration funds are where the fund manager tries to predict the interest rate movement and positions his portfolio.

If he forecasts that the rate will fall, he buys longer-dated paper and vice versa.

If the call goes right, the scheme stands to make huge returns.

In comparison, fund managers focusing on accrual or credit opportunities strategy bet on companies which might not have the best credit rating but are good companies.

The fund manager bets the company's credit rating will improve and the scheme will benefit from this strategy.

This has a good element of credit risk attached.

Reliance Mutual Fund's fixed income head Amit Tripathi believes if investors are looking to put in money for three years and beyond, the allocation should be 70:30 in favour of accrual funds.

But he also believes in active management of accrual funds.

"We would tend to be overweight on accrual portfolios, but won't like to take a zero-one call."

This means the fund manager is flexible and trades depending on situations.

While duration funds will possibly bring returns earlier through higher capital gains, accrual funds, will more than catch up over a period of time.

Good liquidity conditions will also help accrual funds as investors get mark-to-market gains from any situation where interest rates fall and bond prices rise.

"The 30 per cent allocation to duration category is still meaningful, and reflects a strong conviction, in terms of the current and future macro environment, and expectations of rate cuts going forward," adds Tripathi.

Remember the three-year rule

Unless you are saving for creating an emergency fund or one through which you intend to make expenses from time to time, remember this rule.

Investing for three years in a debt fund will help you get an inflation indexation benefit and the tax rate will be 20 per cent on capital gains after accounting for this benefit.

Redemption before three years would lead to addition of capital gains to your income and the taxation will be as per the income tax bracket.

This is why investing for three years or more makes more sense.