Banking and PSU debt funds are the best alternative to bank fixed deposits

Their annual returns are slightly over 8% and can be a good choice for risk-averse investors

The default by the Infrastructure Leasing & Financial Services (IL&FS) and its subsidiaries might have dented debt funds’ popularity, but fixed-income investors need not run away from debt funds completely. There are certain categories like banking and PSU debt funds (BPDFs), where one can make good money with nominal risk. 

“BPDFs are good investment options, as market-related volatility is relatively lower than long-duration funds,” says Joydeep Sen, founder, Wise Investor. 

Agrees S Sridharan, head-financial planning, Wealth Ladder Investment Advisors. “These funds are the best alternative to bank fixed deposits due to low volatility, coupled with low risk. Investors would do well to seek safety in these pseudo-sovereign funds,” said Sridharan.

These are open-end bond funds that invest at least 80 per cent of their corpus into bonds issued by public sector enterprises or banks. These bonds have minimal chance of default and are ranked after government securities. 

Renu Pothen, research head, Fundsupermart.com, says, “Most of these funds follow an accrual strategy and invest in high-quality liquid instruments. Hence, the credit risk tends to be relatively less. We, thus, consider this as an all-season fund category. However, like all other debt funds, they are subject to volatility bouts in the short term, if interest rates decide to take a U-turn.”

To make it sweeter, most of these funds have very low expense ratios – less than 50 basis points. That makes the post-expense returns attractive, compared to other schemes that come with credit risk. For example, HDFC Banking & PSU Debt Fund-Regular Plan offers post expense (8.86-0.80 per cent) yield of 8.06 per cent.

Their returns can improve if interest rates come down. The Reserve Bank of India (RBI) Governor Shaktikanta Das has already announced open market operations of Rs 50,000 crore in January, which will help in providing liquidity to the system and keep yields low.  

BPDF portfolios have varying maturities. Some of the portfolios have average portfolio maturity in excess of three years. These schemes can see capital gains if interest rates come down. When interest rates go down, the price of bonds goes up. Longer the residual term to maturity (average maturity of portfolio), more the susceptibility of the bond (or portfolio) to the changes in interest rates. If the interest rates go up, bond prices fall and inflict losses on fixed income investors.

“In the current scenario, where inflation is in the comfort zone of the RBI, there is a possibility rate could soften in the short term. In this scenario, these funds would benefit from the softening of the policy stance,” says Pothen.

Investors should ideally hold such funds for three years. This serves two purposes – the volatility arising out of interest rate movements going down; it also helps one pocket better returns on post-tax-basis, as long-term capital gains advantage kicks in after three years. 

“While the Securities and Exchange Board of India has not really mandated the average maturity of investments held by these funds, it is currently in the range of one-four years. Risk-averse investors with a three-year-plus time horizon can consider parking their surplus in these funds,” says Pothen. 

The good part is that most of these schemes do not impose any exit load, making them more liquid.