Over the last few years, RBI has consistently reduced the repo rate bringing interest rates on bonds and fixed deposits significantly lower. The trend will continue until inflation remains below 6% and the economy remains upbeat.
Given this scenario, it is no surprise that people are moving away from investing in fixed deposits towards high yielding debt funds. In this post, I will try to simplify basic differences in some of the most popular investment products.
I am taking an Investment time horizon of 3 years after which you get the benefit of indexation for debt mutual funds. Not only do Debt Mutual Funds deliver a higher % rate of return, but the return is (almost) tax free if the fund is held for 3 years or more.
|In (Rs.)||FD||DEBT MUTUAL FUND||CORPORATE/ GOVT. BONDS|
|Return||7.5%*||~ 8.5% – 10.0%||9.75%**|
|Personal Tax Rate||30%||30%||30%|
|Absolute Return generated
(in 3 years)
(@7.5% compounded annually)
(@10.4% – actual growth*** over the past 3 years)
|Indexed Value of Investment||1,00,000||1,26,878||1,00,000|
|Taxable Return Generated – (post indexation)||24,229||7,940||30,864|
|Safety Of Investment||AAA Rated – One level below sovereign guarantee||A mix of credit ratings. Investments range from sovereign to AAA, AA, BBB.
Simply put – Principal amount is safe while your returns could vary.
|Depends on the issue but corporate/ govt. Bonds are typically – AA+ rated or higher indicating high degree of safety|
|Liquidity||Premature withdrawal attracts penalty or reduces returns||Can be sold anytime||Not very liquid- premature sale may be at a lower price.|
* HDFC Fixed Deposit rates for 1 – 5 year tenure.
** Corporate/ Govt. Bonds come with different rates of interest and risk profile. For the purpose of this article, I have taken the most recent Bond Issuance (i.e. SREI Infrastructure which pays [*]
*** Actual growth of a debt fund – ICICI Prudential Income Opportunities Fund (Direct Plan).
^* The rate of tax on debt mutual funds, post indexation is at 20%.
A WORD ON BALANCED FUNDS
I have covered equity mutual funds in other posts. Read here: Mutual Funds Investing Articles. One interesting fund that is gaining popularity which generates fixed income type returns (albeit with a higher degree of risk profile) is the Balanced Fund.
Product note on ICICI Prudential Balanced Advantage Fund
Balanced Advantage Fund – Combines stocks, debt and arbitrage into one portfolio. Balanced Advantage Funds are considered to be less risky as compared to plain vanilla balanced fund and other equity funds.
|Types of Instrument||Normal Allocation|
|Equity & Equity Derivatives (Equity unhedged exposure limited to 80%)||65% to 100%|
|Debt instruments||0% to 35%|
How Balanced Advantage Fund Decides Equity Exposure?
The fund adjusts its direct equity exposure based on whether overall market valuations are expensive or cheap (on the basis of price-to-book value). Thus, if the market’s price-to-book value ratio is low (based on historical values), the fund raises its direct stock exposure and relies less on arbitrage and vice versa.
Market Outperformance – Balanced Advantage Fund has generated returns in every market scenario – Rising, Falling and Flat.
At a given point of time, the Balanced Advantage Fund could have up to 65% allocation to debt and risk free arbitrage investments. At the same time, the equity portion can go up to 65% based on market circumstances. While this caps the upside potential of the fund, it also protects downside risk in equity markets.
BALANCED ADVANTAGE FUND – PLAN OPTIONS
The reason why balanced advantage fund is gaining so much popularity is that it gives fairly steady return with moderate level of risk. If you see the performance of this fund over the past 5 years, the fund has generated an average of 15.8% return (annual).
|Return in (%)||6mth||1yr*||3yr*||5yr*|
|ICICI Pru Balanced Advantage (G)||17.2||13.6||20.3||15.8|
|ICICI Pru Income Opportunities (G)||7.9||10.5||11.5||9.7|
*Returns over 1 year are annualised
Dividend vs Growth Option
The investor can choose dividend payout option or growth option. The fund on average pays ~ 7.5% annualised dividend (tax free) – payable monthly or yearly at the option of the investor. This is higher than the post tax interest on Fixed Deposits. Returns generated over and above this rate are added back to the corpus to buy more funds for the investor.