Five reasons why you should invest in debt mutual funds 

Mutual Fund investment is often associated with equities in India. For the majority of retail investors in the country, mutual funds are a vehicle to invest in the share market indirectly since they lack the skills or the time to buy and sell shares directly. Investment in equities through equity mutual funds has largely worked for investors with most diversified schemes delivering double digits returns in the last five years or more.

This reflects in the declining returns of the equity mutual funds and the near-to-medium-term outlook for the equity markets are not great either. It's time investors start looking at investing in mutual fund schemes that invest in debt securities or debt funds for short.

Here are five reasons why investment in debt funds makes more financial sense than pure equity mutual funds in the current macroeconomic environment:

1. Earn higher yields than bank and post office FDs. Debt funds invest in debt securities such as government bonds, treasury bills, state development loans (SDLs), corporate bonds, commercial paper, certificates of deposits, non-convertible debentures (NCDs) and other such fixed income instruments. These securities pay interest (or coupon) at a fixed interval and the principal (or the face value of the instrument) upon maturity. 

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The yield or interest on many of these instruments is typically higher than interest on bank fixed deposits (FDs). This makes debt funds a better alternative to bank and post office deposits.

The yield on AAA-rated and AA-rated corporate bonds would be even higher than the government bond. The yield on the 10-year government of India bond is up nearly 150 basis points since the beginning of 2021, while banks have hardly increased the interest rate on their fixed deposits.

This makes debt funds a better product for investors and savers who want to earn a fixed interest on their savings rather than risk it in the equity market.

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2. Make money from changes in the interest rates. Debt fund investors benefit from higher yields and profit from a rise in bond prices when the interest rate declines in the market. As a rule, debt funds mostly invest in fixed income instruments that are traded in the financial markets. The price of these debt instruments rises when interest rates decline as there is an inverse relationship between bond prices and interest rates. 

For example, the price of the benchmark 10-year government of India bond rallied by nearly 12 per cent in the 2020 calendar year after the Reserve Bank of India cut interest rate sharply after the break-out of the COVID19 pandemic. Bond prices are now on the decline as interest rises. But the yield to maturity on the debt funds is rising as bond yields are up.

The total return on a debt fund is the price return plus the yield (or coupon) that the instrument provides.

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3. De-risk your portfolio volatility in the equity market. Investment in debt funds is a great way to diversify and de-risk your overall portfolio from the volatility in the equity markets. Equity mutual funds are good for generating higher returns over the long term say 10 years or more, but you also risk losing a big chunk of your money if there is a sudden decline in the market as has happened in the last six months or so. 

An investment portfolio with 60 per cent exposure to equity and 40 percent to the debt fund will out-perform an equity-only fund in volatile times like we are facing right now. And you can change the ratio depending on the market movement or your risk appetite.

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4. Save on capital gains tax. Investment in both debt and equity mutual funds attract short-term and long-term capital gains tax. Besides, equity mutual fund investors also have to pay a dividend distribution tax on the dividend income that they receive from their fund. Short-term capital gains are added to your income and taxed according to your income tax slab rate, while long-term capital gains are taxed at 20 percent plus a 10 percent surcharge and a cess. The overall long-term capital gains tax works out to be around 22.75 per cent.

Debt fund investors however get inflation indexation benefits that translate into a much lower effective tax on debt funds compared to equity mutual funds. To put it simply, debt fund investors only pay tax on the gains that are over and above the underlying rate of inflation during their investment tenure.

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To illustrate, assume that you had bought 500 units of a debt fund at a NAV of Rs 50 in 2016. At the time of redemption in 2021, the NAV had increased to Rs 100 which translates into a capital gain of Rs 50 per unit. So your total long-term capital would be Rs 25,000 (Rs 50 X500). Now assume that the inflation index as provided by the government increased from 240 to 300 which translated into annual inflation of around 4.5 per cent during the period. 

So adjusted for indexation benefit, your net capital gains would now be only Rs 18,750 (Rs 37.5 X 500), nearly 37.5 per cent less than the gross gains of Rs 30,000. So you will pay a long-term capital gains tax of Rs 4290 (@20% plus surcharge & cess) which translates into an effective tax rate of 14.3 per cent only.

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5. Lower Expense Ratio. Mutual funds charge an annual total expense ratio (TER) or the management fee for managing your money. The expense ratio eats into the overall returns that you earn from the fund. If you stay invested in a fund for a longer term, say 5 years or more, annual TER will add up and greatly reduce your net returns.

In this regard, most debt funds beat equity funds by a big margin. Debt funds usually have a lower TER than diversified and actively managed equity mutual funds. For example, it’s not uncommon for equity mutual funds to have a TER of 2.5 per cent or more, while TER for most debt funds can be as low as 0.5 per cent or less. This greatly enhances the net returns for investors especially when it is tough for fund managers to generate higher returns due to a weak market

(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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