Open-Ended Debt Funds Can Be A Better Bet

It is a well known fact that asset allocation holds the key to long-term investment success. Asset allocation is a process that allows investors to allocate their investment into different asset classes based on their risk profile and time horizon. It is equally important to monitor the progress of the portfolio to ensure that it remains on track through one’s defined time horizon.

However, it has been observed that most investors devote a lot of time to monitor their equity holdings as compared to debt investments. One of the reasons for doing so is the volatile nature of equity market and its impact on their portfolios. Since debt investments are perceived to be stable, not many investors feel the need to monitor the progress of their debt portfolio. By doing so, they not only expose themselves to the risks associated with the impact of interest rate movements on market linked products like debt funds but also compromise in terms of returns that they could earn from it. Needless to say, investors do not find debt fund investments quite exciting and hence the focus remains on equity funds. 

The truth, however, is that debt funds too can be volatile as bond prices move inversely to interest rates. When interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Since movements in interest rates can have a significant impact on the performance of medium and long-term debt funds, there is a need to monitor it, not only to realign the portfolio in line with the changing interest rate scenario, but to protect gains and improve the overall performance.

Remember, for debt fund investments, the key is to manage credit and duration risk efficiently. Among debt funds, a major differentiator is the maturity duration of their portfolios. Each category of debt funds has a different risk profile and commensurate return potential. Longer the maturity duration of the portfolio, greater the impact of interest rate changes on it. Similarly, funds that have shorter maturity durations such as ultra short-term debt funds and short-term funds experience lesser impact of the interest rate movements than medium-term debt funds.

That’s why, if you intend to invest for a shorter duration, say more than three months, but less than six months, your focus should be on investing in ultra short-term category of funds. Similarly, if your time horizon is say 12-18 months, short-term debt funds would be apt for you. In case you have a time horizon of two years or more, the toss up could be between medium-term debt or similar funds.

As is evident, debt fund investors need to tread carefully. It is important to keep an eye on the emerging interest rate scenario, as it has a direct impact on the kind of returns you can get from these funds. For example, in a high or rising interest rate scenario, fixed maturity plans will give you better returns than medium-term debt funds.

However, in the current environment where interest rates are on a downward trajectory, open-ended debt funds can be a better bet. It is important to know that there are variety of debt funds in terms of their investment strategies such as accrual and duration. While funds following accrual strategy look to invest in corporate bonds that provide high yields after a thorough credit analysis, a duration fund takes a call on interest rate movement by adjusting the duration of the portfolio to maximise returns.

Apart from investing in the right funds and actively monitoring the portfolio, it is equally important to opt for an appropriate option, that is, dividend payout, dividend reinvestment and growth. In addition to the suitability, tax benefits play an important role in making this decision. Remember, debt funds are required to pay a dividend distribution tax of 28.33 percent while paying dividend to its unit holders. Besides, any capital gains on sale of units before three years is treated as short capital gains and is taxed at one’s applicable income tax rate. Similarly, any capital gains made after three years is treated as long-term capital gains and is taxed at a flat rate of 20 percent after claiming indexation.