• OCTOBER 30, 2014

5 reasons to consider investing in debt funds now!

You may have bought gold this Dhanteras and probably have purchased some shares on the occasion of muhurat trading on the auspicious day of Laxmi Poojan. There is also a tradition of initiating new property deals during Diwali. However, it is unlikely that you considered investing in debt funds this Diwali. You see, debt funds may look boring and unattractive to you; but remember they can play a crucial role in your overall investment portfolio. Unfortunately, many tend to focus on assets that have given good returns in the recent past, ignoring the ones that may have a potential of generating decent returns in future. How have debt funds fared?

How have debt funds fared?
  Returns in %
Category Average of 1 Month 3 Months 6 Months 1 Year 3 Years 5 Years
Money Market Mutual Funds 0.73 2.11 4.23 8.73 8.79 7.81
Short Term Income Funds 1.02 2.57 5.27 9.88 9.23 8.19
Short Term Gilt Funds 1.02 2.34 5.07 8.80 8.47 7.11
Long Term Income Funds 1.36 2.76 5.92 9.53 8.90 7.84
Long Term Gilt Funds 1.75 3.15 7.34 10.08 9.07 7.27
Crisil Short Term Bond Fund Index 0.88 2.43 5.04 9.89 9.13 7.87
Crisil Composite Bond Fund Index 1.30 3.00 6.93 11.20 8.48 7.35
I-Sec Composite Gilt Index 1.64 2.64 7.08 10.70 9.55 7.90
Crisil Liquid Fund Index 0.7 2.2 4.5 9.3 8.9 7.8
NAV data as on October 27, 2014
Returns over 1 year are compounded annualised
(Source: ACE MF, PersonalFN Research)

Over last 3 year, debt funds, especially long term debt funds have not generated attractive returns. This is possibly why they are not very sought after by investors at the moment and also on account of the lack of knowledge over debt mutual funds on the part of investors. Moreover, the tax treatment for debt funds enunciated in budget 2014-15 has made them less attractive. Also, the exuberance in the Indian equity market is encouraging many to cling on to equity and make hay when the sun shines by earning quick returns.

But, you see, the macroeconomic scenario has changed over the last 1 year. The factors that affect the performance of debt mutual funds have gone through a dramatic shift, be it...

  • Inflation and outlook for inflation
  • Monetary policy stance of the central bank;
  • Fiscal condition
  • Current account position
  • Trend in international crude oil prices
  • S&P's outlook for India's sovereign ratings
  • Demand for debt by FIIs and DIIs

At present, things are improving and it appears that may get better going forward. In fact, in the recent past bond prices have rallied with yields on Government securities having mellowed.

Inflation measured by the movement of wholesale price index has come in at 2.38% in September 2014, while retail inflation has fallen to an all-time low of 6.46%. Global crude oil prices have fallen by more than 25% in July-September quarter, which is expected to positively impact inflation. Although food price inflation still remains high, the possibility of a sharp spike in food prices is unlikely considering only moderate loss in farm output on account of lower rainfall this year. The country received 12% lower rainfall on an average in 2014. But you see, late rains might improve soil moisture and help in raising farm produce in rabi season. It appears that, food price inflation may not worsen even if it doesn't mellow further.

Diesel price deregulation has been the boldest decision of the NDA Government so far. This is considered to be an important move in the process of rationalising the fuel subsidy structure. As the diesel is deregulated, consumers should benefit when prices fall and vice versa. Current fall in international crude oil prices has been passed on to consumers as diesel prices have been lowered by Rs 3.4 per liter. The RBI Governor had advocated last month that the Government should deregulate diesel prices.

You see, the U.S. Shale oil boom is expected to set the tone for global oil market, according to Goldman Sachs. OPEC (Organization of the Petroleum Exporting Countries) may lose the control over setting the price trend of crude oil. This is evident by the fact that, despite steep fall in prices, Saudi Arabia has not cut its production as it doesn't want to lose its market share. Weaker global recovery could keep oil demand lower and unaffected supply would mean lower crude oil prices for sustained period. Although there are geopolitical threats always, there is no intermediate threat at least in the foreseeable future. Lower crude oil prices may help India lower inflation. This would not only save fuel subsidies but would save valuable foreign exchange reserves as well. This may bode well for Indian rupee too.

The Government is likely to push at least 30-35 bills through during the upcoming winter session. There are about 67 bill pending; of which 59 in Rajya Sabha and 8 in Lok Sabha. Any positive development on reform front may shore up confidence of investors' about India story. At present although industrial growth still remains weak and since there is no big driver to the higher GDP growth, RBI has kept growth estimates more or less unchanged at 5.5% for the current fiscal year.

For last 3-4 years, the RBI has adopted a tight monetary policy where it kept policy rates high, putting pressure on borrowing rates. But now with improving macroeconomic variables, now there is a sense that conditions are gradually becoming conducive for RBI to accommodate a rate cut going forward which in turn would benefit long term debt mutual funds.

Why you may buy debt funds now?

PersonalFN has herein below listed some factors which may make Indian debt attractive:

  1. Crude oil prices are likely to remain somber internationally

  2. The Government may be able to keep fiscal deficit under check

  3. Current Account Deficit (CAD) could stay under control

  4. If the Government continues to work on its reform agenda, positive sentiment may help buttress India's growth story

  5. Rupee could remain strong as India sits on hefty foreign exchange reserves

What should you as an investor do?

PersonalFN is of the view that, those who have a time horizon of 3 years or more can invest in long term income funds. Dynamic fund may also suit them as fund managers managing these funds have a flexibility to invest across maturities, depending on opportunities. But while you take exposure to long term debt funds ensure that it does not exceed 20% of the entire debt portfolio.

With liquidity conditions being stable in the system and RBI actively managing the same, it would work constructively for yields of shorter maturity papers. Therefore, short term income funds can be explored if you have an investment horizon of 1 to 3 years. But those needing money on short notice should refrain from investing in short term as well as long term income funds, irrespective of how attractive the scenario has become for investing in debt. Ideal choice for such investors could be liquid funds (for an investment horizon of less than 3 months) and / or liquid plus funds, also known as ultra-short term debt funds (for an investment horizon of 3 to 6 months).

PersonalFN is of the view that you should always focus on your asset allocation first, before you think about maximising the returns. Asset allocation should be in line with your financial goals. Holistic approach to investments would help you in the long term. But selection of the category of the mutual fund scheme in the endeavor to achieve your financial goals should be done wisely based on your investment horizon and risk appetite. And remember, debt funds are not risk free.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


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