scorecardresearchAre debt funds here to stay? How long should you stay invested in them?
Should you stay invested in debt funds?

Are debt funds here to stay? How long should you stay invested in them?

Updated: 21 Apr 2023, 09:02 AM IST

Debt funds are the current favorite among investors looking to benefit from higher bond yields. However, AMFI data show unprecedented outflow from debt funds following the loss of indexation and LTCG benefits.

The removal of indexation benefit has taken the sheen off debt mutual funds that were once preferred owing to their moderately good returns and lower tax liability. However, recent data released by the Association of Mutual Funds of India (AMFI) revealed an outflow of 56,884 crores in March 2023 as opposed to 13,815 crores outflow in February 2023. 

Liquid funds, followed by money market funds, experienced the most outflow among the categories, totalling 56,924.13 crores. This is the highest outflow in the past six months, thus, hinting at a lesser interest in debt fund instruments.

Kavitha Krishnan, Senior Analyst – Manager Research, Morningstar India shared, “The significant outflow from debt funds is largely due to the quarter-end phenomenon as redemptions from these instruments are used by corporates to fulfill their tax obligations. Having said that, the magnitude of outflows during this quarter has been relatively lower in comparison to the previous three quarters. This is likely owing to the level of inflows that we have witnessed in debt fund categories like corporate bond funds. There’s also been a significant inflow into passive funds, with Index funds registering inflows to the tune of 27228.30 crores in March.”

Interest rates in fixed deposits have gone up steadily in the past few months with some banks also offering special term deposit schemes. Does this underline the death of debt fund schemes in India or should investors consider short, mid, or long-term investments in debt mutual funds in the current scenario?

Which debt funds should you opt for?

The current yields in bonds and government securities (G-Secs) are high. The Reserve Bank of India (RBI) has also called for a pause in the repo rate hikes. The current market situation is not too great as equities continue to move rangebound without showing a spurt in stock prices. This also explains why many investors may continue to rely on their debt fund investments instead of focusing on equity mutual funds to create a decent corpus in the long run.

Dev Ashish, a SEBI-Registered Investment Advisor and Founder (Stable Investor) shares, “If an investor needs to use debt funds to manage the debt part of his long-term asset-allocated portfolio, then they need to look at categories like Short Duration Funds. Banking & PSU Funds, Corporate Bond Funds, and Gilt/Constant Maturity Funds. A healthy mix of schemes with shorter and longer duration portfolios can work well for long-term portfolio’s debt allocation.”

In a surprise move on April 06, 2023, the RBI governor Shaktikanta Das announced a pause on policy rate hikes in the central bank’s monetary policy. Retail inflation in India came down to 5.66 per cent in March from 6.44 per cent in February this year. The inflation rate being in the 2-6 per cent comfort band for the first time this calendar year is nothing short of great news for the RBI.

Assuming that the RBI does not announce a rate hike in the coming months, debt fund investments may account for higher allocation in one’s investment portfolio.

Rishabh Parakh, Chief Play Officer, NRP Capitals said, “The RBI’s announcement shouldn’t deter investors unless they are planning short-term investments. For a long-term horizon, one should always plan their debt or other investments based on their risk profile and asset allocation, debt is on a par level now with fixed deposits and other fixed instruments, so every investor needs to realign their debt strategy given the tax change brought in.”

Global uncertainties like the fear of escalating geopolitical tensions coupled with poor weather forecasts may mean otherwise for investors hoping that the current band of inflation would continue, thus, prompting the RBI to stay put with its repo rate decisions. Also, unforeseen situations may suddenly lift the pause on rate hikes. Would that affect the debt fund yields?

Viral Bhatt, Founder, Money Mantra says, “If the RBI suddenly lifts the pause on rate hikes, it could impact debt fund yields. Debt funds invest in fixed-income securities such as government, corporate bonds, and money market instruments. As interest rates rise, the value of existing bonds declines, causing their yields to increase.”

“Therefore, if the RBI were to raise interest rates, the yields on fixed-income securities held by debt funds would also increase, leading to higher returns for investors. On the other hand, if the RBI were to keep rates on hold or cut rates, it could lead to a decline in yields and returns for investors in debt funds,” added Bhatt.

He further explained, “It is essential to note that while interest rate movements can impact debt fund yields, they are not the only factor. Other factors, such as credit quality, liquidity and market conditions can also influence returns on debt funds. Investors should always consider their investment objectives, risk appetite, and horizon before investing in any financial instrument including debt funds.”

Suresh Sadagopan, MD & Principal Officer, Ladder7 Wealth Planners explains, “There are lots of global uncertainties for sure. Interest rate cycle, while at near peak, can even go up more based on the ambient conditions. It is a better idea to stay invested in funds that have papers with short residual tenures for now. When there is clarity about the interest rate cycle and when longer tenure papers start offering higher returns than short term, one can revert to medium to long-term funds.”

Deciding on debt fund category

Macroeconomic conditions are beyond us, which is why the choice of debt funds mostly depends on investment tenure. Not all investors may be comfortable continuing with their investments year after year. Some investors look for short-term investment options that may not be beyond a year or more.

Others may prefer mid-term investors ranging between three and four years. Still, others may be willing to continue investing in these funds for five years or more, hoping that the gradual piling of returns coupled with the compounding effect synonymous with the prolonged investment period may help them in creating a decent corpus.

Ashish explained, “Now in these fund categories, the fund portfolios with different maturities will behave differently based on where we are in the rate cycle. While picking funds, it is advisable to pick across categories so that it combines portfolios of different maturities. That way, one can create an all-weather debt portfolio where you will not have to constantly worry about trying to make a move based on the rate-cycle calls. While one category may not be doing well at a given time, there will be another one that will compensate for it.”

Puneet Pal, Head- Fixed Income, PGIM India Mutual Fund further elucidated, “In the current environment, investors with Short Term horizon can consider Money Market Fund category. Those who have a medium-term horizon can look at the Corporate Bond Fund category. Investors who have a long-term horizon and don't wish to take an interest rate call themselves can consider the Dynamic Bond Fund category which can change the duration of the portfolio to capture the changing yields.”

Bank deposits vs debt funds

Debt funds were always preferred over bank deposits owing to the indexation and long-term capital gains tax benefit. However, the Finance Bill 2023 changed everything in favour of bank deposits. Debt funds fell out of favour as term deposit rates continued to go up.

Apart, some banks have come out with innovative schemes like the recent Amrit Kalash Fixed Deposit Scheme announced by the State Bank of India (SBI) and the SBI Sarvottam Term Deposit that promises more than seven per cent interest rate over a limited period. Other government-sponsored schemes are also announcing higher interest rates, thus, lending hope of decent yields to risk-averse investors.

Aditya Shah, Founder, JST Investments shared, “A lot depends on the risk profile of the investor. Debt funds still provide the facility of postponement of taxes. So, individuals in higher tax brackets should stick to debt funds. People who do not have any income can look to park money in fixed deposits as locking the money in long-term deposits can help lock in higher interest rates.”

Pankaj Mathpal, Founder & CEO, Optima Money Managers shared, “Unlike fixed deposits debt funds don't offer guaranteed returns but they have the potential to deliver returns higher than fixed deposits during the same period of investment. With a rise in interest rates bond yields have gone up and it gives investors an opportunity to lock their money in debt funds at higher yields. Fixed deposits and debt funds both can find a place in investors' portfolios and can be considered according to their objective of investment.”

Allocating differently to debt funds

The equity market has been in turmoil since last year and is not expected to recover any time soon given the current economic environment. Debt funds have lost their indexation and tax benefit shield, thus, leaving them vulnerable to competition with bank deposits and innovative mutual fund schemes launched by various fund houses.

How one defines asset allocation has largely changed in the past few years as the effect of the pandemic followed by temporal stability, a full-fledged war between Russia and Ukraine, and recurring bank failures in foreign countries caused many investors to develop a pessimistic approach towards mutual fund investments. The Indian economy though suffered the impact did not succumb to the current extreme global crisis.

Viral Bhatt says, “While there is no doubt that debt mutual funds will likely become less attractive going forward, the argument for shifting investments to fixed deposits may hold poorly for many investors. In the case of FDs, you pay tax every financial year when the bank credits interest to your account, but in the case of debt funds, you may have to pay tax only on withdrawal."

"For example, if you invest in a debt fund and hold it for 5-10 years, you do not pay any taxes for the first 5-10 years. Debt fund allows investors to diversify across instruments and reduces the risks of their money being concentrated in one basket. Unlike FDs, you can make partial withdrawals from debt funds without attracting any penalties. If you invest long-term in FDs and need the money before it matures, the bank would levy a penalty for untimely withdrawal. Debt funds provide liquidity to you," he added.

Debt funds are here to stay, irrespective of how many investors may have pulled out their money from these investments. Ashish advised, “And while picking individual schemes, always give preference to those that follow a conservative approach (and aren’t too adventurous) towards managing their portfolios. A scheme with a larger AUM and which has a reasonably long track record is a better choice. Don’t be unnecessarily tempted by the high returns of a few adventurous schemes as these might be because of unnecessary risk-taking by the fund managers.”

The market suffers a cycle, which means that investments discarded today in favour of another will always find their ground somewhere among other investors who think otherwise or when the market cycle is back in their favour.


We explain what are short term debt funds.
We explain what are short term debt funds.
First Published: 21 Apr 2023, 09:02 AM IST