Why you shd choose a debt mutual fund over FD

Shweta Rajani, Mutual Fund Head, Anand Rathi Wealth, says “it is good to go in for a target maturity fund. There you get options, which are 100% G-Sec paper and you get it for different maturities. So, right now, I just have to give you one or two names that I would recommend. One can go in for an HDFC G-Sec 2036 maturity or you can go in for a Kotak G-Sec 33 maturity. So, these are giving yields which are upwards of 7%, 7.1%. If the interest rate cycle plays out, the duration in these funds is also around eight years and you will get the benefit of that interest rate cut as well as if you hold it on till the maturity, the entry yield, most likely you will end up with that entry yield and getting a 7% plus for a 10-year or a 13-year horizon is also a good yield to get.”

Is it right time to look at debt mutual funds or do you think this is like the peak of that right time that we are talking about?

Shweta Rajani: So, firstly, like I generally mention that you should follow your asset allocation and if your asset allocation says that there is scope for you to have debt, then I think this is still the right time to have debt in your portfolios and within debt, definitely I would say debt mutual funds can be an option to be considered for that debt component. Of course, we are also looking at interest rates which possibly have come down from a 10-year G-Sec hovering at around 7.4 to 7.1, 7.15 levels. But then, it looks like there is a further downside scope in the interest rates. So, one can also play that interest rate cycle and benefit from that little upside one could get over and above the yield because of the interest rate call. So, if you have a debt gap in your portfolio, then definitely you should consider having it.

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But then why should not one only look at fixed deposits where you also have a momentum going on of higher interest rates? Why would you want an investor to consider a debt mutual fund as an option because it is just about interest rates and that earning and that return we are seeing is going up in fixed deposits as well?

Shweta Rajani: Yes, so, the reason why I would still choose a debt mutual fund over and above an FD is one, liquidity. I may want to park my money for three years and I have an option for parking it for a three-year FD. I also have an option of parking it for, let us say, a three-year target maturity fund. What happens is, one, in terms of credit quality, I am getting a 100% G-Sec paper, so it is the top-notch quality that I can get.

Second, liquidity. Most of these target maturity funds do not have exit load or if they have, it is for a very short term, like three-month exit load or something like that. So, in FD, in case you want to have a premature closure, you will have to pay that 1% kind of a penalty. Here, you will not have to do that. I would say the best advantage is that your debt funds are qualified as capital gains versus your interest income that is going to be taxed at a marginal tax rate. The advantage is that in case you have any other short-term capital loss in your book, you can use that to set it off against the gains that you have made over here, so that is still an advantage. So, better quality, better liquidity, and a possible tax advantage in case you have a loss anywhere in your book makes debt funds a better option.

Lastly, like I said, if the interest rate cycle plays out, then the component of modified duration, so you would have, let us say, a one-and-a-half-year modified duration and a target maturity fund for three years. If there is a 50 bps of fall in the bond yields, you will still end up getting that 0.75 extra kicker and let us say that call does not play out for whatever reason, you are still going to get what your entry yield was at the end of the three-year tenure, so that works like an FD plus upside kicker that you could get, so that is where I would choose a mutual fund over an FD.

So, time to look at short-term parking in debt mutual funds or can one also look at long-term scenario considering the interest rate might just start coming down, if not immediately, in a couple of quarters?

Shweta Rajani: Definitely, we are all listening that there is a possibility of rate cuts as well as bond yields coming down. So, it is time to go in for a longer duration in the debt funds. Secondly, if you have a liquidity need, then you would go for a short-term parking and in fact even over there, then I would say rather than looking at debt funds, you can look at arbitrage funds as a category because what happens is right now, an arbitrage fund is also somewhere around that 7% spread but the advantage is that it gets taxed as equity for you.

So, if you stay invested for more than a year, then you will be taxed at 10%. If it is still less than a year of investment horizon, then you are going to still get taxed at 15%. So, if you have money which is there for a few months or maybe a year, year-and-a-half, then arbitrage becomes a better choice than a debt fund. But if you have money that you do not really need for any objective of yours or goal of yours, then going long will give you that benefit of an interest rate fall.

Let us also talk about the funds that you mentioned. I want your recommendations and second, you also spoke about arbitrage funds. How do these funds actually work? For someone who is trying to understand the fixed income market and is looking at debt mutual funds, how would they get all the information regarding an arbitrage fund? How can they place their bet in this kind of an investment right now?

Shweta Rajani: I will first address the debt funds, what kind of funds that you can look at and even you know that within debt you have like 16 different categories. But I would say it is good to go in for a target maturity fund. There you get options, which are 100% G-Sec paper and you get it for different maturities. So, right now, I just have to give you one or two names that I would recommend.

You can go in for an HDFC G-Sec 2036 maturity or you can go in for a Kotak G-Sec 33 maturity. So, these are giving you yields which are today upwards of 7%, 7.1%. So, if the interest rate cycle plays out, the duration in these funds is also around eight years, so you will get the benefit and a good benefit of that interest rate cut as well as if you hold it on till the maturity, the entry yield, most likely you will end up with that entry yield and getting a 7% plus for a 10-year or a 13-year horizon is also a good yield to get, so that is to the first part.

Second, what an arbitrage fund really does is it buys in the cash market and shorts the same stock in the futures market. So, basically, there is no market direction risk that you take in an arbitrage fund because let us say you have bought A stock at Rs 100 in the cash market and you are getting into a contract at the same time to sell it one month later at, let us say, 100.5. So, this 0.5 is the spread you are making.

In effect, in very-very simple terms, for a layman, it means that you are not really concerned about where the stock price goes and one month later you have made your 100.5 minus 100.5 of a spread, which, if you analyse, it will work out to somewhere around a 6%. So, that is the concept of arbitrage.

Therefore, I am saying that it can be a debt alternative because now you are not really taking a market risk over there. However, I would say even for an arbitrage fund, it is good if you stay invested for two-three months over there for it to play out. Right now, the spreads are good, so you are getting around a 7% kind of return in an arbitrage fund. Plus, it has the tax advantage.

So, just to give you some numbers, if I compare a debt fund or an FD which is giving me 7% versus an arbitrage fund which is giving me 7% post tax, the FD would turn out to be at 5% and the arbitrage fund would work out at around 6.35%. So, you get that 1.3% extra return post tax basis and you are not really compromising on the risk, so that has an advantage.

Any other recommendation in debt funds that you might want the investors to consider right now apart from arbitrage, any other category?

Shweta Rajani: Yes, like I was mentioning a target maturity fund and there you can go in for later maturity, would be good in HDFC, Kotak, G-Sec 33, 36 maturity would be a good option.

Roy Walsh

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