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Debt funds' performance struggle may be coming to an end. After delivering sub-par returns the past few years-- due to the low interest earned on their debt holdings and the sustained hike in key RBI rates--debt funds are finally at a stage where they can outpace inflation and deliver slightly higher returns than bank fixed deposits (FD).
The spate of rate hikes has pushed the yield-to-maturity (YTMs) of debt funds to 6-7 per cent for shorter duration funds like liquid funds and 7-8 per cent for longer-duration funds like corporate bond funds. Even if fund management expenses are taken into account, the YTMs of longer duration instruments remain above 6.5 per cent, which is significantly higher than the interest rates being offered by FDs of top banks. At present, the State Bank of India is offering 5.6 per cent interest for 1-2 year deposits and 5.65 per cent for 2-3 year FDs.
YTMs are a good indicator of future debt fund returns but they are not guaranteed like interest rates in FDs.
"Debt fund returns are subject to a host of factors from interest rate changes to liquidity. But despite that, the returns delivered by shorter duration debt funds are most of the time in line with the YTM. For example, the YTM of money market funds is around 6.85 per cent now. Even if we take the mark-to-market effect into account, eventually the investor is likely to get 6.75-6.85 per cent," said Sandeep Bagla, CEO of Trust MF.
The picture is even better in the case of shorter-duration funds like liquid funds and overnight funds whose returns are compared with that of savings bank accounts. These debt funds are now delivering close to 6 per cent as against 3-3.5 per cent being offered by savings accounts of top banks.
The improvement in future return potential of debt funds is starting to bring back retail money from bank FDs to the fixed income offerings (debt funds). MF distributor Ranjit Dani, who had shifted his clients' money from debt funds to bank FDs when their returns deteriorated, says debt funds are back in his recommendation list.
"Most of clients' money meant for shorter-to-medium term investments is currently parked in liquid funds as against bank FDs a few months before. We are waiting for more rate hikes before shifting the money to higher duration debt schemes," said Dani.
Some believe that the YTMs are unlikely to rise any further as future rate hikes are already priced in.
The elevated YTMs come as a relief for debt funds after their poor performance and heightened interest rate risk led to high redemptions in the last one year. Corporate bond funds, which is one of most popular debt funds among retail investors, has witnessed net outflows in 16 out of the 18 months since April 2021. The net outflows amounted to Rs 56,000 crore during this period, resulting in 28 per cent decline in the assets under management of corporate bond funds.
Analysts believe that YTMs may have peaked in most debt fund categories and risk-averse investors can use this opportunity to put money into debt funds for a long term. Target maturity funds with 2028 maturity have a YTM of 7.4 per cent at present. As the expense ratio of these passive debt funds are low, an investor can expect 7.2 per cent return annually, especially if he/she stays invested till maturity.
"Going by the YTMs, one would assume that medium duration funds are a better option right now compared to longer duration funds but that may not be the case for every investor. Investment in shorter duration funds comes with reinvestment risk," said Rahul Jain, Senior VP Research at International Money Matters.
Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows received from an investment at a rate comparable to their current rate of return.
As the present rates are said to be closer to the peak, there is a high chance that the rates will be lower a few years later when the shorter-term investments will be up for re-investment.
Investors of longer-duration funds can expect returns in line with the present YTMs for a longer duration.
