Debt Mutual Funds Seen As A Better Bet In Times Of Falling FD Rates

The Reserve Bank of India has cut interest rate by 175 basis points since the start of 2015, thus bringing down the bank fixed deposit rates sharply. According to estimates, the country's biggest lender State Bank of India (SBI) has brought down its one-year fixed deposit rates (FD) by around 135 basis points during this period.

Bank FD rates could fall further with softening inflation increasing the possibility of more Reserve Bank rate cuts in the future. Should investors look at debt funds closely now?

Apart from falling interest rates, the tax factor is also one of the reasons why financial planners suggest that investors could look at debt mutual funds.

"With fixed deposit rates trending down, the post-tax returns for fixed deposits have become not just unattractive but pose the risk of not helping you to achieve your goals. For those not invested in debt funds, this could be a good time to take a look at the various alternatives that debt funds offer, irrespective of the timeframe you have," says Vidya Bala, head of mutual fund research at Fundsindia.com.

Bank fixed deposit and the benchmark RBI interest rates will continue to move down over the next 18-24 months, says Manoj Nagpal, CEO of Outlook Asia Capital. "This will give investors an opportunity in debt mutual funds to benefit from this interest rate movement in the same period," he says.

Here we look at different types of debt mutual funds:

Liquid funds: They hold debt instruments of extremely short maturities. Investment in these funds could be as short as a day. They offer an alternative to investors for parking their surplus cash for short periods. They have no exit loads and you can redeem investments very easily in these funds. "For these reasons, liquid funds are the perfect alternative to savings bank accounts. Money left idling in your savings bank account, therefore, can be shifted into liquid funds to get higher returns. Investors should, however, not expect past returns as returns may dip a bit over the next one year," says Ms Bala of Fundsindia.com.

Mr Nagpal says investors with a temporary surplus can look at liquid funds with an investment horizon of one day to 30 days.

Ultra short-term funds: As compared to liquid funds, the maturity period of instruments ultra short-term funds hold is higher. Therefore, they require a holding period of around six months to a year, say financial planners. "They are good parking grounds for surplus money that you don't need immediately but may require a little later on and can be good alternatives for fixed deposits less than one year. Investors should however, not expect past returns as returns may dip a bit over the next one year," said Ms Bala of Fundsindia.com.

Short-term debt funds: These debt funds hold instruments of longer maturity periods than ultra short-term funds. They invest in corporate bonds to a greater degree, and to some extent in certificate of deposits (CDs) and commercial papers (CPs). They may also have some holding in short-term government securities. "The average maturity periods of the portfolios will typically be around two years or a maximum of three years. They require a holding period of around two years. They are ideal alternatives at this stage for investors looking at alternatives to fixed deposits of two to three years. Holding longer than three years will provide investors with capital gains indexation benefit," says Ms Bala of Fundsindia.com.

(Also read: Know the income tax rules for mutual fund investments)

Dynamic bond funds: These actively managed funds invest across all classes of debt and money market instruments with no cap on maturity, duration or types of instruments. "These are funds that play the duration game - that is increase their average portfolio maturity by adding more long-dated instruments, and benefiting from a rally during rate cuts. They reduce such maturity once the rate cut regime ends or interest rate is moving up. They instead move to accrual strategy," says Ms Bala of Fundsindia.com.

"These funds are ideal for investors who want to benefit from the interest rate movements, without needing to time their entry and exit... They are ideal substitutes for long-term fixed deposits as they will eliminate the reinvestment risk that fixed deposits have and also deliver better post tax returns if held for over three years," she adds.

Income/income accrual funds: These funds typically have a buy-and-hold strategy on corporate bonds and primarily aim at earning interest income. They aim to provide stable returns by way of accrual and some capital appreciation when the bonds are sold in the market in a rally. "They are good substitutes for fixed deposits for investors wanting stable long-term returns," says Ms Bala.

Credit opportunity funds: These are a sort of accrual funds which seek to generate higher accrual by investing in high yielding papers. "This might mean that the funds take higher risks by investing in lower rated papers, where it believes there could be a re-rating or the quality of the company is still good. This category is suitable for investors with 3-year plus view and willing to take some risks. These funds hold potential to generate higher returns than regular income accrual funds," she says.

Gilt funds: These are funds that invest only in government securities. "While they deliver high returns in a falling rate scenario, their returns quickly reduce once interest rate stabilises or goes up. These funds require timing entry and exit and are not ideal for retail investors," says Ms Bala.

Mr Nagpal of Outlook Asia Capital says gilt funds are "for opportunistic debt investors seeking to ride the interest rate wave".

Disclaimer: Investors are advised to make their own assessment before acting on the information.