FundsIndia Views: The final debate on FD vs. Debt funds

For many of you, looking at the latest FD interest offered by banks and comparing it with the past 1 year returns of debt funds serves up an easy conclusion. FD interest is better than debt funds!

In this article, we’ll take you through why FD rates can seldom be superior to debt funds especially in the short to medium term debt fund category. You just need to know what to compare and how long to hold your fund.

Here is a synopsis:

• You cannot compare the past 1 year returns of debt funds to the future 1-3-year interest rate that your bank will be paying you.
• There are ways in which you can roughly gauge the expected returns from a debt fund, if you look at the right numbers. Yield to maturity is one such key number.
• Current yield to maturity of funds across short to medium term categories tells us that debt funds are the clear winners compared with FDs.

Before we discuss anything about debt funds’ past returns and how to assess how much a fund can deliver, let’s understand why debt funds should deliver more than FDs.

Why debt funds can deliver better

When you invest in a FD, the bank borrows from you and uses the money to lend – at a higher rate. There is a margin for the bank.

When you invest in debt funds, you are indirectly the lender. How? The mutual fund either buys debt instruments in the market or lends directly to companies – either for short term or long term. In other words, the total returns a debt fund generates is from lending/investing in lending instruments. The only margin there is the expense ratio, which is lower than the margin that banks mark up (over FD) for lending.

So what do I mean by saying that you are the lender? Simply that you ought to be earning more than a bank FD. IF you get this basic fact right, you will know why debt funds seek to deliver higher than FD rates.

Comparing past returns of debt funds with future returns of FDs

FD interest rates that you see are what you will be earning in the future. Debt fund returns are what has been earned in the past. Comparing the two can be misleading.

• The last 1-year return of short-term debt funds was 4.7% and that of ultra short/low duration funds was 6.4%. Comparing this with FD returns of 6.8-7% today would make it seem like FDs are better. Here, present FD rates are being compared to past 1-year debt returns. This becomes glaring in a higher rate scenario. When FD interest is hiked, it is natural that the returns from bonds and other papers in which debt funds invest should also go up. You do not factor this when you merely look at past returns from a low rate scenario.
• Two, let us suppose we compare a year ago FD rates of 6.25% to one-year short-term debt fund returns of 4.7% now. This means comparison of past returns in both cases. Would this be the right comparison? No. This is because, the investor did not compare the right category of funds. For 1-year time frames, liquid or ultra short-term debt funds are your solutions. Not short-duration funds. If you look at the 1-year returns of ultra short and liquid funds, they were higher than a year ago FD rates. In other words, comparing FD returns with the right categories of funds for the time frame over which they need to be held is vital. If you are looking at a short-term debt fund and your returns are low even after holding it for 2 years, you will then have to get it reviewed. Otherwise, it is simply a hold.
  If you agree that the past returns may not be representative of the future performance, you might still wonder why short-term debt funds gave a measly 4.7% return in the past year. This was a result of debt market volatility. Unlike FD, the returns of traded bonds tend to be volatile. Hence when a fund holds an AAA-bond that is traded, in a rising rate scenario, it sheds value to keep pace with higher yields. But then, remember, we would have recommended a minimum 2-year time frame for these funds. What happens over that period? The total interest of the underlying bonds over their maturity period helps the fund normalize returns and smoothen the volatility.
• Three, in general, the past 1-year return is not representative of the returns of all categories of debt funds except short tenure funds like liquid funds or ultra short-term funds. Why? Because these categories of funds, given their short tenure, adjust very quickly to the latest interest environment. As the papers they hold have short maturities, this quick maturing results in them constantly buying new papers. In a rising interest rate scenario, these funds will be buying papers with higher coupons. In the present scenario, you will see that liquid funds’ average returns at 6.8% is keeping pace with longer duration FD returns prevailing now. In other categories where holding period is higher (since the funds hold instruments with higher average maturity), the returns will not move up as quickly; the transition will be slower as the funds will have to wait for the tenure of the underlying instruments.

How to gauge future returns

It seems logical to say don’t look at past returns. But then no mutual fund can provide you any assurance on future returns. So how to gauge it?

Except for categories that play duration (gilt, long duration, and dynamic bond to some extent) all other categories from liquid to medium duration funds play an accrual strategy. That is, they seek to generate returns from the coupon (interest) of the underlying papers. Any capital appreciation is incidental gains.

For all categories of debt accrual funds, yield to maturity (YTM) is a reasonable indicator of what you can expect in future. Yield to maturity is the total returns of the papers that the fund holds for the remaining tenure of the papers. For example, if a fund holds various bonds whose average residual maturity is say 2 years and the YTM of such a portfolio is 8%, it means from at the end of 2 years, the portfolio should ideally have generated 8%. This returns less the expense ratio is what the fund should generate.

Let us take an example to illustrate how YTM transforms into returns when the instruments are bought and held.

In the illustration, by end-January 2018, liquid funds on an average had a YTM of 6.5% and the underlying papers were to mature in about a month. At the end of the month, the YTM less the expense ratio is what should ideally be the annualized return if you held the fund for that 1 month. This is how, based on the average maturity and the yield of the current papers, returns are delivered.

For liquid funds, the return is very close to the YTM. Return can vary a bit as the tenure of the funds increases. This is because longer maturity funds have papers that are traded and are volatile during your holding period. But that also means that they can deliver capital appreciation over and above the ‘accrual’ they get from the interest income.

What happened in high FD interest periods

The FD interest today at little under 7% is far from a high interest scenario. Take the last high interest period which was in 2011-12. 1-3-year FDs generated as much as 9.25% then.

Let us see what would have happened had you held on to debt funds over the same period of an FD say for 3 years.

3-year returns between 2011-12 to 2014-15

• In the above data, the post-tax returns of debt funds yielded the same since capital gains indexation over this period ensured there is no taxable gain after indexation. There can be periods when there are taxes too but because of indexation, you pay far lower taxes.
• In general, in a high interest scenario, you tend to gain more from indexation benefit as inflation also creeps up (cost inflation index is derived from inflation numbers). This benefit does not exist in FDs.
• In the above illustration, the returns are all that of category averages. The better funds delivered over 10% pre-tax.
• In any of the above categories, had you seen the past 1-year returns (2010-11), it would have been 5.5% to 6.5%. That would have been a complete put off for you, hastening you to conclude that debt funds yield poor returns. But had you seen the YTM of these funds they would have been in the 8.8-9.6% range for their respective maturities.

For the above period, had you locked into a 1-year FD, please be informed that liquid funds delivered over 9.4% returns in that period. In other words, the respective debt categories did the job of beating FDs over various time frames.

The reason why we have provided the above illustration is for you to know that in high interest scenarios, debt funds ought to be performing and with far higher tax efficiency.

What is the scene today?

The table below will provide you a rough indicator of how what funds are expected to deliver over their holding period. For example, short duration debt funds can be expected to deliver their YTM less expense ratio, provided you hold them for at least 1.9 years. If you hold them for 6 months or 1 year and see that the returns have not come by, then you simply have not done what you ought to do with these funds.

FD returns today 6.8%-7.25%

*All numbers are category averages and as of May 2018

Why you should ignore the intermittent volatility

You may have observed in your holdings that the volatility in returns is least in liquid funds and next to that in ultra short and credit risk categories. This is because much of the papers they hold are held till maturity and often not traded. However, in traded papers, volatility cannot be avoided. It is not just with debt funds, it holds good if you held your own bonds too.

Let me explain this to you with an example. Suppose you held 5 NCDs bought through your demat account in a public offer a year ago. These bonds on an average may deliver you around say 8%. You are happy that this interest accumulates to you or is paid out.

However, if you ever check the price of your bonds in the current market, you will be shocked to know that they would be below the price at which you bought. That means losses. However, this is not something you usually bother about. You are hopeful over the 3 or 5-year maturity period of the bond, you will get the interest (coupon) and on maturity get your principal back. However, if you try to sell in the market, looking at the losses now, you get hurt.

This is the same when it comes to debt funds. They are a portfolio of various debt papers and need to be held for the recommended time frame to ensure you do not suffer losses. When you try to exit ahead of the recommended time frame, you are translating the temporary loss to real loss.

Gauge the expected performance of your debt funds and try to stick to the time frame, to ensure: one, you get better returns than FD; two, you do not suffer losses.

And we think another debate on FD vs Debt funds is uncalled for if you remember that your bank, as a lender, makes more money than the FD holder. In debt funds, you are the lender. The job of your debt fund managers is to ensure you lend prudently!

If you still get spooked by volatility in debt funds, hold funds with minimum maturity (liquid and ultra short/low duration) for longer periods. What causes the damage is to hold funds with longer maturity for shorter periods. The inverse is perfectly ok, in a rising rate scenario.

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 for investment decisions. To know how to read our weekly fund reviews, please click here.