Real Returns. Should seniors invest in debt funds?

With interest rates on bank deposits plummeting, many retirees are on the hunt for other fixed income investments that can deliver better returns.

Today, for such categories of investors, debt mutual funds look like an obvious choice. Debt mutual funds across categories have delivered an impressive 8-12 per cent return in the last three years. Held for three years, debt funds also allow investors to pay less tax on their returns, as their long-term capital gains enjoy indexation benefits.

But looking at these factors alone to switch from a safe bank fixed deposit to debt mutual funds can be a bad move. Here are four things senior citizens need to know before making a switch.

Just as equity mutual funds deliver exceptional returns when stock prices soar, debt funds deliver great returns when bond prices shoot up.

Bond prices tend to shoot up when interest rates in the economy are falling. In the last three years, interest rates have been doing a bungee jump. RBI’s repo rate, which was 8 per cent in January 2014, is now at 6.25 per cent. The rate at which the Government borrows 10-year money has fallen from 9 per cent to 6.8 per cent.

This has triggered a bull market in bonds, which has boosted debt mutual fund returns. In the last three years, debt funds meant for short-term investors such as Liquid Funds, Ultra Short Term Funds and Short Term Funds earned an annual return of 8-9 per cent. Long-term ones such as Medium/Long Term Gilt Funds, Income funds and Credit Opportunities Funds earned a bumper 10-12 per cent.

But for these returns to be repeated for the next three years, interest rates will have to keep falling from their current 6.2 per cent level. This is unlikely. Past rate cycles in India have usually bottomed out at 5.5-6 per cent. Plus, RBI has recently indicated that it may not cut rates further due to rising inflation.

This means that debt mutual funds may now deliver much lower returns, than in the past three years. If interest rates in the economy spike up, they can even suffer losses for short periods.

In short, seniors should reduce their return expectations from debt funds. There’s little likelihood of a double-digit return.

The biggest benefit of a bank FD is that, once you lock in for 3 or 5 years, your returns do not change. With debt mutual funds, the returns can change a lot from year to year. This is because the return delivered by a debt fund depends both on its interest receipts and its NAV movements.

Note that long-term debt funds are the most volatile. If you take stock of returns in the last five years, the average Income Fund earned 8 per cent in 2011 and 10 per cent in 2012. In 2013, its return fell sharply to 5 per cent, before recovering to 13 per cent in 2014. Returns plunged to 7 per cent in 2015 and rose again to 11 per cent in 2016. Long term gilt funds also suffered a roller coaster, with their returns at 6 per cent, 11 per cent, 4 per cent, 7 per cent and 14 per cent, in 2011 to 2016. Short term debt categories such as Liquid and Short term Funds are less volatile. But even these can suffer return swings based on how rates move in the economy. For instance, liquid funds, the most steady category have seen their minimum return at 6.5 per cent and maximum at 9 per cent in five years.

Therefore, seniors cannot rely on debt funds to give them a regular cash flow or income. The ‘income’ from debt funds will fluctuate based on market conditions. They are suited only to investors who plan to grow their corpus at a fixed rate.

First-time investors are often taken aback when they see a debt fund suffer a ‘loss’ in its NAV. Given that the fund receives regular interest from all its bond investments, how can this happen?

Well, debt funds can suffer a fall in their NAV in two circumstances. One, if the interest rates in the economy go up, the prices of the bonds in the fund’s portfolio fall, leading to NAV losses. Debt funds that hold long-term bonds usually suffer sharper losses from such interest rate spikes, than those with short term bonds.

Two, if bonds in the fund’s portfolio suffer a credit downgrade or default, the bond becomes less valuable (or worthless) and the NAV gets marked down to that extent.

Recently, in the Indian market, we have seen both kinds of debt fund losses. In the last three months, RBI’s pause in rate cuts has seen bond yields rise sharply from 6.2 per cent to 6.8 per cent. This has led to gilt funds and dynamic bond funds losing 2-2.5 per cent on their NAV and income funds losing about 1.5 per cent in three months. Liquid and short term funds have avoided losses, but their quarterly return is low, at 1 to 1.4 per cent.

Recently, four debt mutual funds managed by Taurus Mutual Fund (Short Term Income Fund, Ultra Short Term Bond Fund, Dynamic Income Fund and Liquid Fund) saw their NAVs fall by 7-11 per cent on a single day, after one of the bonds held by them (Ballarpur Industries) was downgraded to default grade by India Ratings. These funds had invested 4 to 12 per cent of their assets in this bond. While there have been relatively few instances of debt funds taking a hit from such sudden downgrades, given that some corporates in India are sitting on large debt piles, one cannot rule out such events.

While many fund houses specifically restrict their riskier corporate bond investments to specially named ‘Credit’ or ‘Income’ funds, the Taurus episode tells us that credit risks can creep into Liquid and Short Term funds too.

When such risks hit debt fund NAVs, investors can usually tide over them by sitting tight. Over the long-term, as bonds in the portfolio get replaced and regular interest flows in, the losses tend to even out.

But such risks make debt funds suitable only for investors who can stomach temporary losses. Seniors looking to park emergency money must be warned that debt funds can easily make losses for periods of up to a year.

Tax laws can change

Frequent flip flops in the tax laws in India, tell us that it is never wise to take big investment decisions based on tax breaks alone. These can change in the blink of an eye. Not so long ago, Fixed Maturity Plans enjoyed double indexation benefits, liquid fund dividends suffered low distribution tax and debt funds enjoyed ‘long term’ gains if held for one year.

Therefore, while it is important for seniors to consider tax efficiency while planning their finances, it is not a good idea to switch from a safer to a riskier option mainly for tax breaks.