Are Debt Mutual Funds an Alternative to Fixed Deposits?

Published: July 10, 2016 at 6:51 am

Debt mutual funds are advertised as tax-efficient alternatives to fixed deposits. There is more to investing than  tax-efficiency. Investors must be aware of the associated volatility and how it can impact returns depending on the duration.

Post-tax debt fund returns may or may not be higher than post-tax fixed deposit returns.

The answer to the titular question depends on when you need the money and how you need the money.

If you need the money less than 3 years from when you invest,

(a) do you need the money in one-shot? That is, will you redeem the amount all at once? If so stick to a plain fixed deposit.

Liquid funds can also be used if comfortable, but the tax rate if the same. Arbitrage funds are better from the point of view of tax, but returns need not be higher than a fixed deposit.

One could argue that the TDS and tax payment each FY will reduce the gains of an FD when compared with a debt fund.

This will have an impact only for long durations. See Debt Fund vs FD calculators

All debt funds are volatile. That is, their returns are linked to the bond market and will vary. So before ‘expecting’ a return, from a debt fund (or for that matter any fund), one must be clear about how much the returns can vary and for how long (duration) would the variation be significant (see point (b)).

(b) will you  redeem in parts? That is, take out money from time to time, depending on when you need it?

In this case, debt funds are suitable, provided you have chosen the right category of funds.

I would like to the define the ‘right’ category in the following way:

the average maturity period of the bonds in the folio should be much smaller than the investment duration.

You will find ‘experts’ who would tell you to ‘match’ your investment duration with the average maturity of the fund portfolio. If you did this,  you better not expect anything. Because your returns could swing by a large extent. You may or may not be able to beat post-tax FD returns.

To illustrate this point, let us consider a few debt funds. This article was first written in Nov. 2014. I have now updated this post with a few recent links and an illustration for a short-term gilt fund.

I like the way Franklin Templeton describes its products. You can get a clear snapshot of what the fund is all about. The bulleted fund features below are taken from the FT website.

Franklin India Ultra-Short Bond Fund

  • An open ended income fund with an objective to provide a combination of regular income and high liquidity by investing primarily in a mix of short term debt and money market instruments
  • The fund manager strives to strike an optimum balance between regular income and high liquidity through a judicious mix of short term debt and money market instruments
  • The fund is suitable  for investors with an investment horizon of up to 3 months who prefer accrual based debt products

” investment horizon of up to 3 months” – that sounds like I can use it for any period up to 3 month.

Observed how the rolling returns evolve for different time periods.  A 30-day rolling return means every point in the graph is calculated for a 30-day period.

Notice that as the time period increases the sharp fluctuations in return reduces and the curve becomes smoother. How much would you expect from the fund if you invest f0r 3 months?

I would prefer to hold it for at least 1Y and expect about 7-8% return

Franklin Indian Short-term Income Plan

  • Open-ended short term income fund whose investment objective is to provide stable returns by investing in fixed income instruments
  • Invests primarily in corporate bonds with a focus on higher accrual income
  • The fund focuses on investment opportunities at the short end of the yield curve by maintaining a low average maturity profile
  • The fund is positioned between a liquid fund and an income fund in terms of risk reward
  • This fund is suitable for investors with a time horizon of 9-15 months with moderate risk profile who prefer higher accrual and credit quality focused debt fund

In this case, I would prefer to hold it for at least 2-3Y and expect about 8% return.

For less than 3 year  durations, debt funds are taxed the same way as fixed deposits. So why should I take on more volatility? I might beat FDs, I might not. I would choose debt funds only if I don’t exactly know when I will need the money or if I need to redeem in parts.

For more than 3 years, the indexation benefit will make debt funds more attractive for those in 30% slab. For much longer durations, even those in 20% slab might  benefit.

However, choice of fund matters.

Consider:

Franklin India Income Builder Account

  • Open-ended income fund that strives to deliver superior risk-adjusted returns by actively managing a portfolio of high quality fixed income securities
  • The fund is positioned in the long term bond fund category that focuses investment in high quality fixed income instruments across segments ie G-Secs, Corporate Bonds and Money Market instruments
  • The fund focuses on corporate bonds/ PSUs segment and has a high a moderate to high-interest rate sensitivity
  • The fund is suitable for investors with a time horizon of 1-2 years with a moderate risk profile

Would you trust what the AMC says and buy income builder and hold for 3Y? Depending on when you purchased, the return can be higher or lower than FD return.

DSP BlackRock Treasury Bill Fund

This fund has a mandate to invest only in government bonds of maturity not less than 365 days. It has a concentrated portfolio of 1/2 bonds and cash. The AMC does not recommend any particular duration except that it is suitable for “Income over a short-term investment horizon”.

Notice how this short-term gilt fund can be quite volatile for short durations. Only when we look at rolling returns over a few years, do returns settle down. Better to use it for above 3-year periods

When it comes to short-term goals (anything less than 5Y), the very last thing that I want to do is monitor my portfolio and make course corrections. I would prefer to choose something that has low volatility so that I can be a buy and hold investor. I would prefer to focus on my long term goals.

Always account for the stress associated with holding a debt fund.

Choose short-duration funds. It is a low-stress option (relatively). Just don’t expect too much more than FDs.

Never speak ill of a fixed deposit. It is a wonderful product. Just don’t use it for long-term goals.

If the AMC recommends an investment duration, be sure to triple the estimate.  This applies to equity funds as well (PPFAS says min 5 years, meaning you should hold it for 15 years or more !!).

You can start with these links on how to choose debt mutual funds:
How to select mutual fund categories suitable for your financial goals

How to choose debt mutual funds with no credit risk and low volatility

Conclusions

  1. Do not use debt funds if you do not have an idea of how volatile they can be.
  2. The average maturity of the portfolio should be much lower than the investment duration of the fund.
    • If your investment duration is 3 years, then an average maturity of a few months is good (liquid funds)
    • If your investment duration is 10 years, then an average maturity of 1-2 years is good.
      • Ultra-short-term funds ~ 1Y.
      • Short-term gilts ~1-3Y if you want to avoid credit risk.
      • Income funds from solid bonds from banks and PSUs or a bit of corporate debt ~ 1-3Y is also okay.
  3. A fixed deposit is a wonderful product for investment durations less than 3 years. After all, there is more to investing than obtaining real returns
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