How to select the right debt mutual funds for your portfolio: Part 3

In the first part of this article, How to select the right debt funds for your portfolio – Part 1, we discussed how to select the right debt funds based on your investment tenure.

In the second part How to select the right debt funds for your portfolio – Part 2, we discussed,how you can select debt funds based on your risk / return expectations.

Now, let us move on to the third and concluding part of the series.

Selecting debt funds based on return expectations (steady income versus capital growth)

Some investors prefer steady income, while others prefer capital growth. In the example, at the start of the second part of this article, Ramesh wanted capital growth for his daughter’s college education. On the other hand, Akash, a retired senior citizen, wants steady income from his investments because his investments are his family’s only source of income after retirement.

Remember, Ramesh’s investment horizon was three years, before his daughter went to college. Akash’s investment horizon is longer than Ramesh’s but his risk / return preferences are the opposite because of his income needs. Akash wants more predictability in his income from investment because his family’s lifestyle is dependent on it.

So far, we have classified debt funds based on their maturity profiles. Debt funds can also be classified based on their investment strategies. There are two types of investment strategies in debt funds.

• Income Accrual:

  Fund managers employing this strategy hold the bonds in their portfolio till maturity and accrue income from the coupons (interest) paid by the bonds. The bond price does not matter because the bonds are held till maturity, when the face value of the bond will be paid back to the investors.



• Duration Calls:

  Fund managers employing this strategy will take active duration calls, based on their interest rate outlook. If they expect interest rates to fall in the near to medium term, they will invest in long duration bonds. Price change is directly related to the duration of the bond and long duration bonds benefit the most from interest rate fall. On the other hand, if they expect prices to rise in the future, they will invest in short duration bonds and invest in higher yielding bonds to lock in higher income.

Let us now discuss how to select debt funds based on your return expectations.

• If you want steady income from your fixed income investment, then you should invest in accrual based debt funds. Though the yields will change with the interest rate regime, there will be some short term predictability of returns.


• If you want higher yet steady income from your fixed income investment, then you can evaluate Credit Opportunities Funds. These funds also follow accrual strategy, but they invest in slightly lower rated papers (bonds) to get higher yields. Bonds with lower credit ratings have to pay higher coupon rates (interest) to the investors; hence investors get better returns. In addition to higher yields, if the credit quality of some of the bonds in the fund portfolio improves then the bond price will increase and the investor will make capital gains. The flipside is that, if the credit quality worsens, then the fund NAV will fall. You can balance between credit risk and return expectations, by looking at the average credit quality of these funds and invest accordingly.


• If you want capital growth in your fixed income investment, then you should invest in duration based debt funds. You should be aware that, the duration calls can sometimes go wrong and in that case, you will get low returns. When investing in duration based debt funds, you should form a band of returns expectations. You should invest in duration based funds, if you expect interest rates to fall in the near to moderate term.


• If you are unsure about the trajectory of interest and want the best of both worlds, you can invest in Dynamic Bond funds. Fund managers would change allocation towards different debt instruments as per their future prediction on change in interest rates. Dynamic bond funds can give good returns in different interest rate scenarios.

The tax advantage

Debt funds are also more tax friendly than most other traditional fixed income investment instruments over a long investment horizon. Over a 3 year period, capital gains from debt funds are taxed at 20% after allowing for indexation benefits. While in debt funds, the fund house has to pay dividend distribution tax (DDT) at the rate of 28.33%, it is still lower than tax rate on most fixed income investments for investors in the highest tax bracket. The applicable effective tax rate (including cess) for investors in the Rs 10 – 50 lakhs income slab is 30.9%. For investors in the Rs 50 lakhs to 1 Crore income slab, the effective tax rate including surcharge and cess is almost 34%. For investors in the Rs 1 Crore+ income slab, the effective tax rate including surcharge and cess is almost 35.5%.

Systematic withdrawal plans (SWP) from debt funds is also more tax efficient than, interest income from most traditional fixed income schemes because the investor is taxed only on the capital gains from the units being redeemed instead of the interest accrued on the entire investment. Furthermore, mutual fund capital gains are not subject to TDS for resident Indians.

Conclusion

Debt mutual funds are great investment options for a wide variety of investment needs, including tenure, risk preferences and return expectations. We would like our readers of Advisorkhoj to understand these wonderful products and take full advantage of it. In this three part post, we discussed how to select debt funds based on your investment tenure, risk appetite and return expectations. Investors should discuss with their financial advisors, which debt funds are most suitable for their investment needs.