With the interest rates of bank Fixed Deposits (FDs) moving south, we have seen increased interest in debt funds. If you have made a switch from FDs to debt funds now, we believe it is a good move.
Debt funds not only ensure that you have low reinvestment risk (case in point being the fall in FD rates now if you have deposits maturing soon), but also provide better post-tax returns, especially for holding periods of three years or more.
The most popular category seems to be the dynamic bond fund category. With bank FD rates at 7-7.5 per cent, this category’s double-digit returns over 1, 3 and 5-year time-frames do seem far superior.
But, while dynamic bonds hold potential to deliver better-than-FD returns, we would like you to be aware of the following:
- The double-digit returns that you see now may not sustain over the long term. In other words, do not look at the returns prevailing now and expect the same over the next 5 years.
- While taking exposure to dynamic bond funds, you should also take some exposure to another debt category called income accrual funds, or, simply, income funds. These funds are known to deliver steadier returns with lesser volatility.
Before we move on to showing you why you should balance between the two categories we mentioned, let us quickly bring out the distinction between them.
Dynamic bond and income funds
Dynamic bond funds play on the interest rate cycle and mostly take exposure to government securities, also called gilts, along with some exposure to corporate bonds. As their name suggests, they try to dynamically manage their average maturity to ensure they gain from rate movements.
For instance, in a falling rate scenario, they anticipate such falls and go for long-term gilts, and thus gain from a price rally when yields fall. Similarly, in times of rising interest rates, they reduce their average maturity and stay in short-term instruments to reduce volatility and get returns. The key risk here is the interest rate. If they get the rate movement wrong, their returns drop.
Income accrual funds, on the other hand, predominantly buy and hold short-term and medium-term corporate bonds and other corporate instruments and simply gain from the interest (coupon rate) that accrues from those bonds. They do not try to actively time their entry and exit based on interest rate.
Their acumen would lie in finding the right opportunities with good rates but without much credit risk. Hence, the risk here, if there is any, would be credit risk – that is, the risk of entering into poor quality bonds. But then there are times that the quality of the debt instrument they hold improves and is re-rated by credit rating agencies; thus providing gains, if the instrument is listed.
Within the income accrual category – you may choose to take lower risks and stick to funds that hold high-quality (AAA-rated) instruments or decide to go with funds (called credit opportunities funds) that take higher risks to get a higher coupon rate.
Historical data suggests that income accrual funds may not provide periods of high returns like dynamic bond funds, but they do not see sharp swings in their returns either. In other words, they provide steadier returns across time-frames and are not dependent on rate cycles.
Having a combination of these two categories of funds will ensure that you play both these risks – interest rate risk and credit risk – in a balanced manner.
What to expect
The table below tells you the kind of returns that dynamic bond funds and income funds delivered as a category, when their returns were rolled daily for 1-year time-frames over three years.
While dynamic bond funds at present appear to have delivered high returns, in reality they did not do so steadily. The average 1-year rolling returns given below show that, in reality, income funds outperformed.
Clearly, while dynamic bond funds have the potential to deliver very high 1-year returns as they are currently doing, they are also much more volatile as you can see from the higher standard deviation and low ‘worst 1-year return’.
|Avg. rolling 1-year returns
|Avg. standard deviation
|Best 1-year rolling return
|Worst 1-year rolling return
|Dynamic bond funds
|Income funds (including credit opportunity funds)
|Rolling returns over 3 years ending August 16, 2016. Only funds with track record over this period were considered.
Over a 3-year return period too (when rolled daily over five years), income funds as a category delivered about 8.3 per cent on an average, while dynamic bond funds were at a more modest 7.8 per cent. While good funds from these categories would have delivered way higher for you; the point to note here is that income accrual provides opportunities across rate cycles and generates more steady returns as a result of its strategy.
Among FundsIndia’s Select Funds we would go with HDFC Medium Term Opportunities for a low-risk income accrual strategy, and with Reliance Regular Savings – Debt or Franklin India Income Builder if you are looking for higher risk income strategies. In the dynamic bond space, Birla Sun Life Dynamic Bond and UTI Dynamic Bond are in our list at this point. All these need a 3-year plus view. With dynamic bond funds, returns may taper off a bit post 12-18 months. Still, post the capital gains indexation benefit after three years, they will likely beat FDs by a mile.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.
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