The restrictions placed on depositors of Punjab and Maharashtra Cooperative Bank and the suspension of interest payment and withdrawal from DHFL fixed deposits (FDs) were two severe jolts dealt to fixed income investors in the recent past. When situations such as these arise, investors scramble for safety and familiarity. However, this flight to safety could come at the cost of lower returns. Barring the small savings schemes, whose interest rates are kept artificially high, safe products have seen a fall in rates recently.

For example, State Bank of India’s term deposits with tenors ranging from two years to 10 years offer an interest rate of 6.25% per annum. If you are in the 20% tax bracket, the post-tax return on this will be around 5%, close to the long-term inflation rate of 4% and below the 6-7% rate typically taken for financial planning.

Debt funds could be your alternative to FDs as they manage risks better and have the potential to generate better returns.

Returns

“These days it is getting simpler to introduce debt funds to clients given the poor post-tax returns on FDs,” said Deepali Sen, founder partner of Srujan Financial Advisers LLP. Debt funds benefit from gain in the value of bonds in the portfolio when interest rates fall even if new investments are earning lower coupon income. When rates rise, the fund is able to invest fresh inflows and reinvest the proceeds from maturing bonds at higher rates although the existing securities see a decline in value. If you had invested in a well-performing short duration fund for three years, you would have earned around 8%, while a three-year FD from SBI would have earned just 6.85%, albeit guaranteed.

The difference in post-tax returns would be much higher. “For investors who like to see an indicative return, I point out the yield to maturity (YTM) which net of expenses is what the investor will make,” said Saurabh Bansal, founder, Finatwork Investment Advisor, a Sebi Registered Investment Advisor.

Range of schemes

To manage the risk of volatility, choose a fund whose portfolio duration is not more than your holding period. “We match the debt fund to the client’s goal, holding period and risk profile,” said Bansal.

Different funds have different durations ranging from one night (overnight funds) to 10 years. The tenor and therefore, the level of volatility differs.

Also, different categories of funds offer different profiles of maturity and credit risk. “Mutual funds give you the flexibility to decide what type of risk you wish to embrace. There are products available to cater to different needs and a product like the banking and PSU fund gives you a similar credit profile as an FD,” said Bansal.

Understand the risk implication of the portfolio. “Expectation on volatility is set at the time of investing. I ensure that my clients are informed and have understood the nature of risks so that there is no dissonance if things go wrong,” said Sen.

Diversified portfolio

Debt funds invest in a diversified portfolio, limiting their exposure to a security that may be downgraded or defaults despite best research. For example, in the Essel group, DHFL and other distressed debt issues, the exposure of open-ended funds was typically below 5%, though some funds did have higher exposure. Regulatory caps ensure which securities a debt fund can invest in and how much, ensuring a diversified portfolio. Debt funds can also identify potential trouble spots ahead and exit early.

Unlike debt funds, the risk of concentration is high in investments like fixed deposits where investors hold large sums of money and run the risk of losing it all if things go wrong. There is very little information available to investors that they can use to evaluate their investments and they have very few options for exit or redressal.

Open-ended funds, on the other hand, are required to provide regular information on portfolio and performance to investors and can exit at the current value of the units at any time.

Liquidity

Unlike FDs, open-ended debt funds allow you to withdraw money any time you want. “Unlike the FD, where around 1% of your return gets docked if you exit prematurely, debt funds allow you to withdraw when you need the money. Exit loads on short- and medium-duration funds typically apply only if withdrawal is made before a year,” said Sen.

This feature also allows you to sign up for periodic withdrawals from the funds if you want to structure a regular payout.

Taxation

You get the benefit of indexation on returns from debt funds held for more than 36 months. The cost at which you invested is revised up to account for inflation and this notionally brings down the taxable capital gains, reducing the tax liability. In comparison, interest earned on FDs is charged to tax at the depositor’s income tax slab rate. “The tax arbitrage that definitely exists on holding periods of more than three years is a very persuasive argument,” said Bansal.

Mint take

In the past, debt funds have rightly been held to task for following the letter and not the spirit of the regulations in the way the portfolios are managed. Selecting well-managed funds in terms of returns and the way a portfolio is managed is your responsibility. If a fund is taking too many concentrated bets or more credit risk than you like, then it’s perhaps time to exit.

Debt funds are required to regularly put out detailed information about the portfolio and performance; use it to assess the fund’s continued suitability. Plan ahead to invest in a way that makes debt funds tax efficient.