Debt mutual funds: Should you bet for short term, mid-term or long term amid the current rate regime?

Bond yields responded favourably to the monetary policy announcement when the RBI opted to hold the repo rate against the street expectation of 25 bps. However, debt mutual funds experienced an outflow of ₹56,884 crore in March 2023 as opposed to ₹13,815 crore in February. The debt category has had total outflows of ₹81,015.51 crore in the calendar year 2023 according to data provided by the Association of Mutual Funds in India (AMFI) and another disappointing announcement debt mutual fund investors is the long-term capital gain (LTCG) tax advantage and indexation for debt mutual funds was eliminated by the Finance Act 2023. So let's hear from many industry experts on whether investors should make short-, mid-, or long-term investments in debt mutual funds in the current environment. 

Gautam Kalia, Senior VP and Super Investor at Sharekhan by BNP Paribas

Currently yields are at a relatively higher level and if investment tenure is long term, then at current interest rate scenario, investor should bet on long duration through dynamic bond funds.

1. Trends to witness after the recent policy announcement of Rbi. Expectations on upcoming rate cycle and inflation level?

The RBI has unchanged the repo rate in its recent policy and has re-iterated its commitment to bringing down inflation to 4%. If inflation continues to trend downward, it is unlikely that RBI will hike rates. Obviously, global uncertainties and weather forecast impacting agricultural output can both play spoilsport. The RBI has kept the window open for further tightening in the future if required.

2. Which debt mutual fund category should I pick? 

Considering the current interest rate scenario, investors should go with dynamic bond category schemes, which change the underlying portfolio of the scheme as per the interest rate scenarios.

3. Best strategy to go for long term, mid-term or short term?

Investors with long-term tenure should go with dynamic bond schemes and for medium tenure, should go with Corporate bonds and short duration schemes. if the tenure is short term then investors may consider low duration category schemes.

4. How to manage your debt portfolio after tweaks made in the financial bill 2023?

The long term tax advantage of debt mutual funds was removed in the finance bill 2023. Now, for all investments made after 1st April 2023, investors will have to pay taxes as per their income tax slab on the capital gains of debt mutual funds. From the taxation point of view, debt mutual funds are now at par with bank fixed deposits. Since existing debt investments (invested before 1st April 2023) are not impacted, clients should continue with that allocation. 

Going forward, clients can manage asset allocation at a portfolio level through reducing their pure equity exposure and moving debt to aggressive hybrid funds to maintain the tax benefit. If that is not possible, clients will need to weigh whether the risk premium of Debt funds over FDs is still atrractive to them given the increased possibility of stable and downward trending interest rates in the near future. 

Aniruddha Bose, Chief Business Officer, FinEdge

In this month’s policy meet, the MPC left interest rates unchanged. The Feb meet’s hawkish tone and last month’s surprise jump in inflation had fuelled a consensus view of a 25-bps hike, so this turned out to be a positive surprise for bond markets. The policy stance was retained as ‘withdrawal of accommodation’ to ensure a balance between controlling inflation and supporting growth. The RBI also lowered its CPI inflation estimate for FY24 from 5.3% to 5.2%; while keeping its GDP growth forecast unchanged at 6.5%.  This suggests that the we are at or near terminal repo rates for this cycle and will probably see material hikes only if inflation moves up significantly from here on.

Given the current outlook, TMF’s (Target Maturity Funds) with a residual maturity of 3-4 years look sensible. Most of these funds have a YTM of 7.4% to 7.6% now, and since they invest into G Sec and SDLs with a roll down strategy, one can be reasonably assured of earning these returns (pre-tax) over the next 3 years. Additionally - with the rate hiking cycle approaching its end and inflation data prints trending down, the probability of capital gains in long-term debt funds has increased. To take advantage of this, debt fund investors could consider making a tactical allocation to 10-year constant maturity GILT funds, but with an understanding of the risks involved. 

Investors with very short-term horizons (3-6 months) should stick with liquid funds now. Tightening liquidity conditions will be a plus for short-term rates and therefore, for liquid funds. After having a dismal time in the post COVID environment that was awash with excess liquidity, they are already on the recovery path - having returned in excess of 5.7% over the past year. We can expect this trend to continue for the medium term.

S. Ravi Promoter & Managing Partner, Ravi Rajan & Co. LLP

Navigating the world of debt mutual funds can be overwhelming, especially when trying to determine the best investment horizon amid the current rate regime. From the recent policy announcement by RBI to potential changes in interest rates and inflation levels, there are many factors to consider before deciding whether to invest in short term, mid term, or long term debt funds.

1. Short-term debt funds may outperform long-term funds based on recent RBI policy announcements, but this may change depending on the upcoming rate cycle and inflation levels.

2. Debt mutual fund category to pick depends on risk appetite and investment horizon. Liquid/ultra-short-term for stability, medium/long-term for more risk.

3. Staggered approach recommended for long-term investments to mitigate interest rate risks.

4. Regularly review and rebalance debt portfolio to align with financial goals and risk profile after tweaks made in the financial bill 2023.

5. Diversified debt mutual fund portfolio with a mix of short-term, medium-term, and long-term funds can mitigate interest rate risks and offer better returns over the long term.

6. Stay cautious and monitor debt fund performance closely with upcoming rate cycles and inflation levels.

7. Do due diligence and consult with a financial advisor before making any investment decisions.

Rahul Jain, President & Head, Nuvama Wealth

After the recent surprise move by RBI to keep the Repo rate unchanged, it is widely believed that the rate hike cycle is largely over. Receding worries about CAD and inflation and the fading growth momentum underpin this belief. Prudence suggests investors keep an eye on the way inflation and CAD shape up in the coming quarters. Notably, the RBI has maintained its stance of withdrawal of accommodation, leaving the door open for future rate hikes should inflation or CAD slip out of control. Predictions about monsoons and the impact of the El Nino phenomenon will also play a significant role in shaping the RBI’s views on interest rates in the forthcoming reviews.

When it comes to debt funds, there is an abundance problem. Investors frequently require clarification on which category of funds to invest in. To make it easier for investors, the regulator has clearly defined each debt fund category so that investors can make the best decision. The best way to choose the best debt fund category is to match the investment horizon with the average maturity of the funds. For example, liquid funds are best if the investment is for a few days or weeks. Similarly, medium to long-term funds can be appropriate if it is for 2-3 years. Investors must consult their investment advisors if they are not able to make up their mind.

We think the rate hike cycle is largely over. First, growth momentum has started to fade. Manufacturing exports are in contraction, and rising real rates and tightening fiscal policy could also tilt domestic pockets into a slowdown. Second, CAD/BoP concerns have eased, and third, the global economic dynamic has transitioned from inflationary to deflationary in the wake of the banking sector turmoil in the US and Europe. Thus, we expect inflation/macro-stability concerns of FY23 to give way to growth worries in FY24. In such an environment, rate hikes are unwarranted. The timing and pace of easing shall be determined by the Fed’s actions and growth/inflation outcomes.

Existing long-term debt fund investors must hold them until they need the funds to meet any financial goals. They will benefit from indexation and a 20% tax rate. Investors looking to invest fresh funds in debt can compare debt funds to other fixed income instruments and select the one that best meets their needs in terms of liquidity, rate of return, and safety.

Those seeking higher yields should consider various bonds and NCDs with good yields and credit ratings. Investors should not avoid long-term debt funds. Remember that long-term debt funds can benefit from future rate cuts by generating capital gains as bond prices rise.

Dr. Kirti Sharma, Assistant Professor of Accounts & Finance at Great Lakes Institute of Management, Gurgaon

An increased capital expenditure for developing infrastructure needs an effervescent capital market for financing. The Indian bond market has a lot of scope for growth but the recent change in the taxation for debt instruments may prove to be detrimental to the growth of the corporate bond market in the long run. Retail investors may not be very keen on parking funds in the debt funds for a long period of time as no benefit for indexation shall be available. Since the provision applies to investments made after 1 April 2023, appreciatively previous ones will not get impacted.

From financial year 2023, any debt fund/gilt fund/funds that invest abroad/gold or silver funds/mutual funds/conservative hybrid funds which are purchased and sold after 1 April 2023 shall not be taxed as long term but as short term capital gain which means that the benefit of indexation will not apply and the rate of tax will be higher. For a retail investor Mutual Fund may now be considered at par with bank fixed deposits. Alternative investment options which have favourable tax treatment might gain popularity.

Nevertheless, debt funds remain an attractive investment option for short term say upto six months. If the return on FD is compared with the debt funds, long run FD returns are lucrative but upto six months they are very low. Hence investors may still prefer debt funds in the short term.

Mr. Sandeep Bagla,CEO, TRUST MF 

1. RBI kept repo rates unchanged, increasing the probability that rates have heat their peak levels in the current rate cycle. Markets are likely to see benign interest rate scenario in the coming months

2. Investors should divide their debt fund portfolio in 3 components - 1. Money market funds which provide relatively high interest income and high degree of liquidity 2. Corporate bond funds - which combines high credit quality, reasonable interest rates and moderate possibility of capital gains 3. Long duration funds - which could generate capital gains and handsome returns  if and when interest rates were to soften

3. Strategy could be to allocate funds in high quality portfolio of fixed income funds to provide stability to the over all portfolio. Investors can construct and rebalance portfolio with the help of advice of their MF distributor

4. The rate cycle could reverse in the coming months as inflation could reach sub 5% levels in a year's time

5. Pay tax on the income generated on the debt portfolio

Alekh Yadav, Head of Investment Products, Sanctum Wealth

We believe we may have seen peak bond yields and interest rates. The interest cycle from hereon may reverse and investors with time horizon of more than one year may make decent returns. If the investment in debt mutual fund is a tactical allocation, then one could look at existing as rates appear to be bottoming. if investment is strategic in nature, then investor may consider remaking invested for longer time period.  

The RBI decided to pause in its latest monetary policy against a market expectation of 25bps points. Bond yields reacted positively to the monetary policy announcement. While the RBI has kept room open for further rate hikes, we believe the RBI may remain on hold going forward unless global central banks appear to hawkish or global inflation remain stubbornly elevated. We think bond yields may not move higher from hereon and May start declining gradually. Thus, investors can start locking in yields and gradually adding duration 

If the investment horizon is 3-5 investors can look at target maturity funds. The core debt allocation would have to be made via short-term debt MFs and corporate bond funds. A part of money can also be invested in higher duration funds to benefit from decline in interest rates going forward. 

We believe the RBI May be on hold going forward, unless the global central banks appear to hawkish or global inflation remains stubbornly elevated. In India inflations should start to cool down gradually but is likely to remain close to the upper target range of RBI. 

Investors will still need to allocate to debt mutual funds given benefits like liquidity, diversification, possibility of making higher returns by either taking duration or credit risk and possibility for mark to market gains in an interest rate declining scenario. However, the post tax return expectations will now have to be moderated. A few investment options like REITs and INVITs, structured credit funds (for HNI investors), selective direct bonds and a few hybrid mutual fund categories have become attractive alternatives to debt mutual fund. Having said that, bulk of fixed income allocation will continue to be via debt mutual funds.

Mr. Abhinav Angirish, Founder, Investonline.in

In addition to the necessity of maintaining a constant balance between debt and equity based on time horizons and risk tolerance, there are some tailwinds that will improve the performance of debt funds over the coming years in comparison to what we have seen in the past few.

The yields across tenors and rating categories have significantly improved over the past 18 months, which is the first and primary factor. Since one year has passed, the entire G-Sec curve has yielded more than 7%, and for corporates, it is closer to or more than 8%. Second, the RBI and other central banks around the world have raised interest rates repeatedly in an effort to lower inflation moving forward. Additionally, macroeconomic indicators like the fiscal deficit and the current account deficit, which affect aggregate demand and inflation pressures, are also getting better, i.e. on a downward trend. Third, thanks to highly robust and conservative balance sheets and a strong domestic economic environment, credit risk is generally low across the corporate spectrum.

Thus, it is a favorable opportunity to invest in debt funds throughout the duration and credit spectrum. The only thing that investors need to be cautious about is making the best product decision based on their investing time horizon and risk tolerance. 

When we talk about interest rate, inflation is the most significant factor because it is the RBI's first priority when determining policy rates. According to popular belief, expectations regarding the RBI's rate action are shaped by the most recent inflation figures.

The Monetary Policy Committee (MPC) of the RBI examines inflation projections, typically looking out one year. Forward estimates are favorable, despite the fact that our CPI inflation in February 2023 was higher than the RBI's tolerance zone of 6% at 6.44%. The CPI inflation rate is predicted by the RBI to be 5% in the quarter ending in April-June 2023, 5.4% in the following two quarters, and 5.6% in the quarter ending in January-March 2024. 

One could argue that the RBI's inflation target is 4% with a 6% tolerance range as the upper limit. Yet it must be viewed in its proper context. Inflation is strong on a global scale, and this has an impact on our inflation as well. In light of this situation, accepting inflation within the tolerance range and achieving the primary goal of 4% over the next two years shouldn't provide any significant challenges.

The fact that debt mutual funds provide comparatively constant returns while maintaining capital protection is a significant advantage of investing in them.

Nonetheless, there has been a change in the tax treatment of capital gains from debt mutual funds. After April 1st, 2023, investors in debt funds with an equity ratio of less than 35% will no longer be eligible for LTCG tax benefits on capital gains from those assets.

Before, following indexation advantages, units held for more than 36 months were subject to a 20% tax. Any profits made after April 1st will now be taxed according to the applicable tax bracket, regardless of the holding period.

While the flat 20% tax rate and indexation will not apply to investments made after March 31, 2023 with a duration of less than 36 months, they will apply to investments made before that date.

To reap the rewards, it would be advisable for investors to hold their debt fund assets for as long as they can.

Debt mutual funds continue to be a superior debt investment choice when compared to other debt investments, even after the revisions.

The payment of tax on any capital gains derived from investments in debt funds won't be required until the units are redeemed. Conversely, interest income from other debt instruments is added to income and taxed at the normal rates.

In sum, investors can still put their money into debt mutual funds and reap the benefits of high accrual income on high-quality portfolios and the possibility of future capital gains.

Suman Bannerjee, CIO, Hedonova

Debt mutual funds are suitable for investors with a short to medium-term investment horizon and seeking regular income.

Recent RBI policy announcements suggest a potential rise in interest rates. Investors should consider short to medium-term debt mutual funds that can benefit from higher interest rates.

For investors seeking safety, low-risk debt funds such as liquid funds or overnight funds can be suitable.

The best strategy for investing in debt mutual funds depends on the investor's risk tolerance, investment horizon, and financial goals.

Investors should stay updated on the upcoming rate cycle and inflation levels, which can impact debt fund performance. Additionally, tweaks made in the financial bill 2023 can also impact debt portfolio management.

Rajul Kothair, Partner, Capital League

This decision depends on whether you are investing for a strategic or tactical allocation. As part of a strategic allocation if your time horizon is 3 to 12 months, investing in arbitrage funds would be recommended because of tax efficiency. For 1 to 3 years consider short term funds. If the tenure is more than 3 years, it would be best to consider medium term or dynamic bond funds, as yields in the 3 to 7 years segment are a sweet spot. 

Additionally in dynamic funds the fund manager can change the duration according to the view on interest rates. Investors who would like to lock in at a certain yield can look at investing in Target Maturity funds of appropriate maturity. When It comes to a tactical investment, one can invest in long term bond funds for the next 12 to 18 months as long as duration funds will benefit from capital appreciation as and when interest rates see a downward cycle.