FUND FLAVOUR

December 2014

If you are buying a debt fund to give your portfolio stability or to help generate income, then your strategy may pay off. Investing in debt mutual funds usually entails less risk and less reward than investing in equity mutual funds. But debt funds, like any other mutual fund, do involve some degree of investment risk. Liquid funds, ultra-short, short term, intermediate, and long term are various categories that do not perform alike or carry the same risks. For instance, instruments in the portfolios of liquid funds have a maturity period of less than 91 days. Hence, the interest rate risk does not exist to the extent it does in long-term debt funds. Moreover, the fund managers tend to stick to a high credit rating to maintain a very high quality portfolio which makes it less susceptible to default risk. Linked to the above is liquidity risk. If the fund manager invests in poorly rated paper, it could turn into a liquidity risk. A fund faces liquidity risk if the fund manager is not able to sell his paper due to lack of demand for that particular security. Liquidity risk is high in funds with a portfolio of low credit quality. No market-related investment is risk free, be it equity or debt. While debt funds are not as perilous as equity funds, these are the risks that they carry.

New kid off the block…

To discourage investors from buying gold, RBI launched inflation index bonds which were meant to provide a hedge against inflation. After RBI launched these bonds in 2013, DWS, HDFC, and SBI have launched their Inflation Index Bond Funds which exclusively invest in these bonds. Axis Mutual Fund too has filed an offer document with SEBI to launch its inflation index bond fund. Inflation Indexed Bonds (IIB) are issued by the Government and have coupon and principal linked to inflation. Having a tenure of 10 years, these bonds are linked to the Wholesale Price Index (WPI). For instance, if these bonds are available at an yield of 3% above WPI, and WPI for the full year is 7%, IIB will offer a coupon rate of 10 % (7%+3%) during that year.  

Not only do these bonds offer safety of principal, but they can also offer capital appreciation if the rate of inflation increases. These bonds are ideal for risk-averse investors since they are backed by the government and are as safe as other sovereign bonds. On the flip side, fixed deposits and tax-free bonds are better alternatives to IIBs. Tax free bonds provide fixed interest throughout the term. Contrary to this, the return from IIBs is dependent on the rate of inflation. IIBs are treated like debt funds for taxation. These bonds are suitable for investors falling in the lower tax bracket (up to 10%). The demand for these bonds is low mainly because of lack of awareness. About 10% to 20% of your portfolio can be allocated towards these bonds.

Norms to strengthen the base

SEBI observed that many debt oriented schemes are operating with a very low AUM. It is of the view that it is imperative that debt oriented schemes have an adequate corpus to ensure adherence to the investment objectives as stated in the Scheme Information Document and compliance with investment restrictions specified under SEBI (Mutual Funds) Regulations, 1996. Hence, it has mandated fund houses to have a minimum subscription amount of at least Rs 20 crore in the case of debt oriented and balanced schemes at the time of new fund offer and at least Rs 10 crore in the case of other schemes. An average AUM of Rs 20 crore on a half-yearly rolling basis has to be maintained for open ended debt oriented schemes. AMCs will have to report the compliance of this regulation to SEBI in the Half Yearly Trustee Reports. If the above cannot be maintained, the AMC will have to scale up the AUM of such a scheme within 6 months so as to comply, failing which the scheme will be wound up.

Debt funds underperform

In terms of returns to investors, most of the debt-based mutual funds in the country underperformed compared to their respective S&P benchmark indices, over the last five years, according to the report by S&P Dow Jones Indices. The comparative analysis between debt-based funds and S&P India's two benchmark indices -- government bond index and bond index -- is for the five years ended June 2014. According to the report by S&P Dow Jones Indices, more than 78% mutual funds in Indian government bonds failed to beat S&P India Government Bond Index, while 53% Indian Composite Bond funds were outperformed by S&P India Bond Index. The interest rate remained higher and impacted the active managers in the Indian government bond peer group which underperformed the S&P India Government Bond Index over one, three and five-year periods. Almost a quarter of the funds in this peer group disappeared over the five-year period. Active managers in the Indian composite bond category also could not outperform the benchmark in the five-year period.

Advantages unearthed

Debt funds offer several advantages but small investors know little about them and fail to keep abreast of what is happening on the debt fund front. Here are the salient points for consideration:

Tax rules have changed

There are three things proposed in the 2014 budget that are negative for investors in debt funds.

a. Investors have to hold a debt fund for 36 months, to get any benefit of long-term capital gain (LTCG).  Currently this number is 12 months.

b. The choice of paying taxes at 10% without indexation on LTCG is no longer available. LTCG from non-equity oriented funds would be taxed at 20% tax after indexation.

c. Dividends distributed by mutual funds are subject to dividend distribution tax (DDT). This will now be paid on the gross basis and not on net amount of dividend paid.

FMPs with tenure less than 36 months, redeemed after April 1, 2014, will no longer be eligible for indexation benefits, or lower long-term capital gains tax.  The redemption proceeds will be subject to tax at the marginal rate of tax of the investor (plus surcharge and cess).

There might be a slight advantage in opting for dividend option for a holding period of less than three years, if the investor falls in the 30% bracket.  This is because dividend is subject to dividend distribution tax (DDT) at 25% for individual investors.  For investors whose tax rate is lower than 25%, growth option is better than dividend option, since their STCG will be taxed at their marginal rates of taxation. The rate of DDT is flat 25% and hurts investors with tax rate lower than 25%. Investors in bank deposits only have to pay TDS (10%). They may also be able to claim some refunds.

No tax deduction at source

A tax-friendly feature of debt funds is that there is no tax deduction at source (TDS) on the gains. In fixed deposits, if your interest income exceeds Rs 10,000 a year, the bank will deduct 10.3% from this income. If you are not liable to pay tax, you will have to submit either Form 15H or 15G to avoid TDS. The other problem is that the income from fixed deposits is taxed on an annual basis. You will get the money once the deposit matures, but the income is taxed every year. In debt funds, the tax is deferred indefinitely till the investor redeems his units. In addition, the gains from a debt fund can be set off against short-term and long-term capital losses you may have suffered in other investments.

Returns are market-linked

Though they are looking very promising, debt funds do not offer assured returns. In fact, they can also churn out losses in case the interest rates go up, although the possibility of this happening is remote. The maturity profile of the holdings defines the volatility of a debt fund. Funds holding short-term bonds are not very volatile and give returns roughly equivalent to the prevailing interest rate. But the funds that invest in long-term bonds are more sensitive to changes in interest rates. If rates decline, the value of bonds in their portfolio shoots up, leading to capital gains for the investor. While the average short-term debt fund has given 9.8% returns in the past year, some long-term bond funds have shot up by 14-15% during the same period.

Keep in mind the exit load

A debt fund is very liquid since you can withdraw your investments at any time and the money is in your bank account within a day. However, some funds levy a penalty for exiting before the minimum period. The exit load can vary from 0.5% to 2%, while the minimum period can range from six months to up to two years. Check the exit load of the fund before you invest. Even a 1% exit load can shave off a significant portion from your gains.

Create SIPs in equity fund via debt fund

If you have a large sum to invest, invest it in a debt fund and start a systematic transfer plan to the equity fund of your choice. Every month, a fixed sum will flow out from the debt fund into the equity scheme. Compared to the 4% your money would have earned in the savings bank account, it has the potential to earn 9-10% in the debt fund. Similarly, if you want regular retirement income from your investment, invest in a debt fund and start a systematic withdrawal plan. Every month a fixed sum will be redeemed from your investment.