With the interest rates of bank Fixed Deposits (FDs) moving south, we have seen increased interest in debt funds. If you have made a switch from FDs to debt funds now, we believe it is a good move.
Debt funds not only ensure that you have low reinvestment risk (case in point being the fall in FD rates now if you have deposits maturing soon), but also provide better post-tax returns, especially for holding periods of three years or more.
The most popular category seems to be the dynamic bond fund category. With bank FD rates at 7-7.5 per cent, this category’s double-digit returns over 1, 3 and 5-year time-frames do seem far superior.
But, while dynamic bonds hold potential to deliver better-than-FD returns, we would like you to be aware of the following:
- The double-digit returns that you see now may not sustain over the long term. In other words, do not look at the returns prevailing now and expect the same over the next 5 years.
- While taking exposure to dynamic bond funds, you should also take some exposure to another debt category called income accrual funds, or, simply, income funds. These funds are known to deliver steadier returns with lesser volatility.
Before we move on to showing you why you should balance between the two categories we mentioned, let us quickly bring out the distinction between them.
Dynamic bond and income funds
Dynamic bond funds play on the interest rate cycle and mostly take exposure to government securities, also called gilts, along with some exposure to corporate bonds. As their name suggests, they try to dynamically manage their average maturity to ensure they gain from rate movements.
For instance, in a falling rate scenario, they anticipate such falls and go for long-term gilts, and thus gain from a price rally when yields fall. Similarly, in times of rising interest rates, they reduce their average maturity and stay in short-term instruments to reduce volatility and get returns. The key risk here is the interest rate. If they get the rate movement wrong, their returns drop.
Income accrual funds, on the other hand, predominantly buy and hold short-term and medium-term corporate bonds and other corporate instruments and simply gain from the interest (coupon rate) that accrues from those bonds. They do not try to actively time their entry and exit based on interest rate.
Their acumen would lie in finding the right opportunities with good rates but without much credit risk. Hence, the risk here, if there is any, would be credit risk – that is, the risk of entering into poor quality bonds. But then there are times that the quality of the debt instrument they hold improves and is re-rated by credit rating agencies; thus providing gains, if the instrument is listed.
Within the income accrual category – you may choose to take lower risks and stick to funds that hold high-quality (AAA-rated) instruments or decide to go with funds (called credit opportunities funds) that take higher risks to get a higher coupon rate.
Historical data suggests that income accrual funds may not provide periods of high returns like dynamic bond funds, but they do not see sharp swings in their returns either. In other words, they provide steadier returns across time-frames and are not dependent on rate cycles.
Having a combination of these two categories of funds will ensure that you play both these risks – interest rate risk and credit risk – in a balanced manner.
What to expect
The table below tells you the kind of returns that dynamic bond funds and income funds delivered as a category, when their returns were rolled daily for 1-year time-frames over three years.
While dynamic bond funds at present appear to have delivered high returns, in reality they did not do so steadily. The average 1-year rolling returns given below show that, in reality, income funds outperformed.
Clearly, while dynamic bond funds have the potential to deliver very high 1-year returns as they are currently doing, they are also much more volatile as you can see from the higher standard deviation and low ‘worst 1-year return’.
| Category | Avg. rolling 1-year returns | Avg. standard deviation | Best 1-year rolling return | Worst 1-year rolling return |
|---|---|---|---|---|
| Dynamic bond funds | 8.4% | 4.0% | 21.3% | -4.6% |
| Income funds (including credit opportunity funds) | 9.0% | 1.8% | 16.8% | 0.8% |
| Rolling returns over 3 years ending August 16, 2016. Only funds with track record over this period were considered. | ||||
Over a 3-year return period too (when rolled daily over five years), income funds as a category delivered about 8.3 per cent on an average, while dynamic bond funds were at a more modest 7.8 per cent. While good funds from these categories would have delivered way higher for you; the point to note here is that income accrual provides opportunities across rate cycles and generates more steady returns as a result of its strategy.
Among FundsIndia’s Select Funds we would go with HDFC Medium Term Opportunities for a low-risk income accrual strategy, and with Reliance Regular Savings – Debt or Franklin India Income Builder if you are looking for higher risk income strategies. In the dynamic bond space, Birla Sun Life Dynamic Bond and UTI Dynamic Bond are in our list at this point. All these need a 3-year plus view. With dynamic bond funds, returns may taper off a bit post 12-18 months. Still, post the capital gains indexation benefit after three years, they will likely beat FDs by a mile.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.
- Merger of Navi Overnight Fund into Navi Liquid Fund and Navi Conservative Hybrid Fund into Navi Aggressive Hybrid Fund
- Intimation of suspension of subscription in Bandhan US Equity Fund of Fund
Winning Funds, Losing Streaks: Decoding the Mystery of Short-Term Underperformance
Wealth Conversations – November 2024- Notice of Change in Fundamental Attributes of DSP Equity & Bond Fund and DSP Quant Fund
Thanks for the informative article. However, I wish to know whether debt funds, be it a Dynamic Bond fund or any other debt fund, can be used as a better return alternative to bank FD even in shorter terms (i.e. less than 36 months period) for an individual in 30% income tax bracket.
I have observed that good performing debt funds may beat FD returns or arbitrage fund returns, even after paying 30% income tax on the returns in short term.
Kindly ratify whether this analysis is correct.
Hemant, at the current low interest rate juncture in deposits, yes your analysis will hold true for even less than 3 years. But you get immense post-tax efficient returns if you hold for over 3 years whichever interest rate cycle you are in. thanks, Vidya
A bit of confusion around the fund categorization.
Birla SL Dynamic Bond Fund: Listed under ‘Debt funds – long term’ in the FI ‘Select’ list, but categorized as ‘Debt – Short-term funds’ when you open its page (by clicking on the link).
UTI Dynamic Bond Fund: Mentioned as a ‘Dynamic Bond’ fund in this article but categorized as ‘Debt – Income funds’ in its page.
Karthik,
Very valid questions:-) Unfortunately, BSL Dynamic Bond has Crisil short term bond as it’s index and hence the short-term category by our data service provider (they go by what is mentioned in SID as benchmark). Also, there is no separate classification between dynamic bond and income for most data providers (since dynamic bodn funds have crisil composite bond as their index). The classification is not by us. Hence, I would suggest suggest for advisory purpose, you go with the ‘long-term’ research classification. We do our own classification, based on average maturity, credit risk etc. at research. We are in the process of using our own classification uniformly for display purpose in a few quarters from now…instead of using the data provider’s classification. To sum up, ignore the classification in the explorer page and go with select funds 🙂 Thanks for raising it. regards, Vidya
Good Article .. Thanks
Thanks for the informative article. However, I wish to know whether debt funds, be it a Dynamic Bond fund or any other debt fund, can be used as a better return alternative to bank FD even in shorter terms (i.e. less than 36 months period) for an individual in 30% income tax bracket.
I have observed that good performing debt funds may beat FD returns or arbitrage fund returns, even after paying 30% income tax on the returns in short term.
Kindly ratify whether this analysis is correct.
Hemant, at the current low interest rate juncture in deposits, yes your analysis will hold true for even less than 3 years. But you get immense post-tax efficient returns if you hold for over 3 years whichever interest rate cycle you are in. thanks, Vidya
well explained!!
Hi Vidya,
Does the above logic is also Valid for NRI. I am currently having NRE FD that mature in next 2 to 3 month, as I understand NRE FD does not have
much tax implication, Please advise.
Thanks
Hello Ramprakash – NRE deposits do not have taxes. However, given the low rate of interest now if you renew (at 7.5% or so), you will get better post-tax benefit if you invest in a debt fund, especially for 3-year plus time frame. Thanks, Vidya
Hi Vidya,
Does the above logic is also Valid for NRI. I am currently having NRE FD that mature in next 2 to 3 month, as I understand NRE FD does not have
much tax implication, Please advise.
Thanks
Hello Ramprakash – NRE deposits do not have taxes. However, given the low rate of interest now if you renew (at 7.5% or so), you will get better post-tax benefit if you invest in a debt fund, especially for 3-year plus time frame. Thanks, Vidya
Hi
I am an NRI and would like to know whether the above logic also applies to NRE FD accounts. I have a few
NRE FD that are about to mature in next 2 -3 months, so would like to know whether the above recommended debt strategy can beat the post tax returns as compared to NRE FD, or should I continue to reinvest in NRE FD.
Hello Ramprakash,
Sorry for the delayed reply. Yes, it will apply to NRIs too at this stage as deposit rates are falling. However,as an NRI, you will have TDS on the capital gains. Still post-tax at least for the next few years, your returns will likely be better than FD, especially if you hold for 3 years and avail indexation benefit.
Hi Vidya
Thanks for the advise and guidance. I will proceed for debt funds investment.
what strategy should I follow for investing in debt funds? should it be lumpsum or SIPs?
I am investing in MFs using Fundsindia and currently speculating on investing in debt funds.
According to me, it should be lumpsum if I want to take advantage of 3 year period and indexation benefits.
SIPs in debt funds would just negate the whole idea of debt funds if we are looking at it as a replacement of bank FDs.
Please advice.
Hello Deep,
If you are investing specifically in debt and have a reasonable sum to deploy, it can be lumpsum. If you are investing for the long term and allocating some amount to debt, use SIP. This is more to do with whether you are using debt for asset allocation with equity) or just investing in debt.
what strategy should I follow for investing in debt funds? should it be lumpsum or SIPs?
I am investing in MFs using Fundsindia and currently speculating on investing in debt funds.
According to me, it should be lumpsum if I want to take advantage of 3 year period and indexation benefits.
SIPs in debt funds would just negate the whole idea of debt funds if we are looking at it as a replacement of bank FDs.
Please advice.
Hello Deep,
If you are investing specifically in debt and have a reasonable sum to deploy, it can be lumpsum. If you are investing for the long term and allocating some amount to debt, use SIP. This is more to do with whether you are using debt for asset allocation with equity) or just investing in debt.
Dear Vidya,
One question that i always had:
1. What should someone do when his fund is not doing well, (compared to peers or benchmark)?
2. If the answer to the above questions is ‘to sell it off’ or do a ‘SWP’, what should be the frequency that you suggest to do a SWP?
3. When should the answer to the question 1, is to ‘hold’?
4. What are the ‘other options’?
Hello Sankar:
1. Watch performance for 2-3 quarters and if it is still underperforming, stop SIPs first (but start in a better fund right away) and hold after 6 quarters or so, if it remains bad, you can consider exiting. But make sure you are moving to a better fund and not allowing the money to lie in your bank account.
2. When moving, lumpsum is fine. when you move within an asset class, there is no risk of timing.
thanks
Vidya
Hi Vidya,
For some surplus fund available in the savings account, what should be the best strategy at the current scenario and considering 2-3 years horizon? Should one go for a debt fund or liquid fund?
Thanks.
Hello Raj, sorry for the delayed response. For your time frame you can invest in a short-term debt fund. It would deliver better than a liquid fund. Thanks, Vidya
well explained!!
Good Article .. Thanks
Dear Vidya,
One question that i always had:
1. What should someone do when his fund is not doing well, (compared to peers or benchmark)?
2. If the answer to the above questions is ‘to sell it off’ or do a ‘SWP’, what should be the frequency that you suggest to do a SWP?
3. When should the answer to the question 1, is to ‘hold’?
4. What are the ‘other options’?
Hello Sankar:
1. Watch performance for 2-3 quarters and if it is still underperforming, stop SIPs first (but start in a better fund right away) and hold after 6 quarters or so, if it remains bad, you can consider exiting. But make sure you are moving to a better fund and not allowing the money to lie in your bank account.
2. When moving, lumpsum is fine. when you move within an asset class, there is no risk of timing.
thanks
Vidya
A bit of confusion around the fund categorization.
Birla SL Dynamic Bond Fund: Listed under ‘Debt funds – long term’ in the FI ‘Select’ list, but categorized as ‘Debt – Short-term funds’ when you open its page (by clicking on the link).
UTI Dynamic Bond Fund: Mentioned as a ‘Dynamic Bond’ fund in this article but categorized as ‘Debt – Income funds’ in its page.
Karthik,
Very valid questions:-) Unfortunately, BSL Dynamic Bond has Crisil short term bond as it’s index and hence the short-term category by our data service provider (they go by what is mentioned in SID as benchmark). Also, there is no separate classification between dynamic bond and income for most data providers (since dynamic bodn funds have crisil composite bond as their index). The classification is not by us. Hence, I would suggest suggest for advisory purpose, you go with the ‘long-term’ research classification. We do our own classification, based on average maturity, credit risk etc. at research. We are in the process of using our own classification uniformly for display purpose in a few quarters from now…instead of using the data provider’s classification. To sum up, ignore the classification in the explorer page and go with select funds 🙂 Thanks for raising it. regards, Vidya
Hi Vidya,
For some surplus fund available in the savings account, what should be the best strategy at the current scenario and considering 2-3 years horizon? Should one go for a debt fund or liquid fund?
Thanks.
Hello Raj, sorry for the delayed response. For your time frame you can invest in a short-term debt fund. It would deliver better than a liquid fund. Thanks, Vidya
Hi
I am an NRI and would like to know whether the above logic also applies to NRE FD accounts. I have a few
NRE FD that are about to mature in next 2 -3 months, so would like to know whether the above recommended debt strategy can beat the post tax returns as compared to NRE FD, or should I continue to reinvest in NRE FD.
Hello Ramprakash,
Sorry for the delayed reply. Yes, it will apply to NRIs too at this stage as deposit rates are falling. However,as an NRI, you will have TDS on the capital gains. Still post-tax at least for the next few years, your returns will likely be better than FD, especially if you hold for 3 years and avail indexation benefit.
Hi Vidya
Thanks for the advise and guidance. I will proceed for debt funds investment.