How should one play debt funds in a market with terrible mood swings like this? Read on

Debt fund strategy is framed keeping several key factors such as interest rates, tax implications, investment duration, risk tolerance, and market trends in mind.

In the current scenario, investors should consider a tactical approach towards their debt fund investments, keeping in mind the expected decrease in interest rates.

2024 could be a favourable one for the bond market as central banks are expected to lower policy rates. The quantum and timing of rate cuts will vary across countries depending on the state of their respective economies. 

“As far as India is concerned, we believe that the RBI may consider rate cuts from October 2024 onwards after thoroughly reviewing factors such as the new Union Budget, ongoing inflationary pressures, the global growth-inflation dynamic, and the policy rate environment,” says Dhawal Dalal, CIO-Fixed Income at Edelweiss MF.

So one strategy would be to invest in long-term debt funds or dynamic bond funds with a modified duration of 7-11 years. The anticipated decline in interest rates can provide a potential capital appreciation of 8-10% besides the Yield-To-Maturity (YTM). This presents an opportunity for investors to book profits and pay their marginal tax upon redemption. 

“Tactical call on interest rates – Investing at the long end – Long-term debt funds and Dynamic Bond Funds with a modified duration of 7-11 years. Interest rates are expected to come off by 75-100 basis points in the next 12-18 months. The expected fall in interest rates can give a capital appreciation of 8-10% in addition to the YTM. Investors can book profits and on redemption pay their marginal rate of tax. Investing in Medium-term Bond funds – This segment is also attractive from the perspective of making an additional return from capital appreciation with a lower risk compared to long-duration funds.

Medium-term bond funds also hold value, offering additional returns from capital appreciation with lesser risk compared to long-duration funds. This translates into a reasonable margin of safety despite potential market volatility,” said Rajul Kothari, partner Client Associates, a boutique wealth management company.

Debt funds primarily focus on investing in fixed-income securities such as government- or corporate bonds and money market instruments. The prices of these securities are directly affected by interest rate changes, as bond prices and interest rates are inversely proportional. When interest rates go up, the prices of existing bonds decline, and MFs need to mark their net asset value (NAV) to the market daily, and hence the MTM losses.

Continuing investments in short to medium term debt funds, including corporate debt funds, can also be beneficial. These higher-yielding options aid in diversification and steady income through Systematic Withdrawal Plans (SWP). They also offer liquidity, professional management, flexible withdrawal options, and defer taxes until redemption. This stands in contrast to Fixed Deposits (FDs) and bonds, where tax is payable on assumed interest every quarter or Financial Year (FY).

“Fixed Income investors can consider investing in debt mutual categories i.e. Medium Duration Funds, Corporate Bond Funds and Banking & PSU Debt Funds. Medium duration funds maintain average maturity in the range of 3-4 years while corporate bond fund invest primarily in the paper issued by the highest rated entity and Banking & PSU funds primarily invest into the paper issued by banks and PSU which offers higher level of safety (Security issued by banks and PSU have higher ratings),” said Rajiv Bajaj, Chairman & MD, BajajCapital.

One must remember that capital gains from debt funds can be offset against short-term losses from other investments. 

Moreover, the ease of transactions in debt funds, as opposed to buying bonds or other fixed-income securities, which require demat and broking accounts, adds to their appeal.

A noteworthy point is that new investments into existing debt fund schemes should be made in a new folio. It protects the tax benefits of previous investments. 

The redemption in debt funds happens on a first-in-first-out (FIFO) basis. Therefore, if fresh investments are made in an old folio, the older units, which enjoy the earlier tax regime, will be redeemed first, leading to potential tax disadvantages.

In conclusion, despite tax law changes, debt funds remain a compelling investment option for various reasons. Aware, strategic investment will help manage the dynamics, promising sound financial planning.