Forget bank FDs; the time could be ripe for short to medium duration funds

Effective October 01, 2019, Indian banks have shifted to external benchmark based pricing of loans.

Oct 16, 2019 11:10 IST India Infoline News Service

Investments
Over the last few days several banks have been cutting the rate of interest paid on FDs, leaving a lot of investors surprised. The reasons are not far to seek. Effective October 01, 2019, Indian banks have shifted to external benchmark based pricing of loans. That means floating rate loans will now be linked to an external benchmark like repo rate or T-Bill yield. With loan rates now almost falling in tandem with the cut in repo rates, investors in bank FDs need to be prepared for further cuts in deposit rates too. What is the answer?
 
How about short to medium duration funds?
In its classification of mutual funds, SEBI has identified 16 classes of debt funds. Short duration funds are classified as funds with duration of 1-3 years while medium duration funds are classified as funds with duration of 3-4 years. For simplicity, we will merge these two groups and evaluate why this can be superior to bank FDs. It can actually offer higher growth, better tax efficiency with low levels of risk.
 
First, what exactly is duration all about? Duration is different from the tenure of the bond. Duration is the number of years in which the bond investor recovers the principal invested including the impact of interest received. In case of a 5 year bond paying 7% coupon interest, the duration will be less than 5 years because you start recovering your principal partially even before the actual redemption. Without getting into the nitty-gritty’s of duration, this concept is used for asset liability matching. That means; if you have a liability after 5 years, then you match that with bond having duration of 5 years.
 
Focus on medium to short duration funds, but keep it simple
The first important factor is to keep it simple. There are high risk medium duration fund that invest in credit risk bonds, structures etc. These can be kept aside for the time being. The focus must be on high quality (ideally AAA) bond portfolio with duration of up to 4 years.
Medium duration funds are different from short duration funds in the sense that they benefit from a fall in interest rates. With GDP growth slipping to 5% and IIP in negative territory, there is an informal commitment from the MPC to cut rates as long as inflation is supportive. That will work in favour of medium duration funds. Secondly, the price in medium duration funds is much lesser than long duration funds. These long duration funds can get risky if the yields start to harden. The basic rule is that you only allocate that portion to medium duration funds which you can lock in for 3-4 years.
 
Proof of the pudding – How short to medium duration funds performed?
Let us consider the Morningstar ranking of the top performing short to medium duration funds. We will rank on 1-year returns, although we will consider a longer time frame of 3-5 years to smooth the unevenness of returns. Here we are only considering growth plans and the regular options for better comparison.
Fund Name 1-Year Returns (%) 3-Year Returns (%) 5-Year Returns (%)
SBI Magnum Medium Duration Fund (G) 11.314% 8.395% 9.338%
IDFC Bond Fund - Medium term plan (G) 10.969% 7.104% 8.069%
HDFC Medium Term Debt Plan (G) 9.542% 6.644% 7.989%
Sundaram Medium Term Bond (G) 9.061% 6.056% 7.604%
ICICI Pru Medium Term Bond Fund (G) 8.241% 6.472% 7.895%
Data Source: Morningstar
 
If we take a 5 year period as the benchmark, the short to medium term debt funds have been giving around 8-9% return on a compounded basis. That is at least 200 basis points higher than what you could earn on a bank FD. This is 5 year returns, so we cannot even complain about short term cycles. Over the next couple of years, even assuming a maximum cut of 50 bps by the RBI, the gap between the returns on short to medium duration funds and bank FDs should only widen.
 
Finally, don’t forget the all important tax aspect
Till now, we have been only talking about pre-tax returns. If you consider the returns in post tax terms, the bank FD will be taxed at your peak rate (20% or 30%) each year irrespective of the holding period. The reason we have considered short to medium duration funds is to hold the fund for a period of 3 years or more. Since this is a growth plan, you get the added benefit of indexation. Here is how it works for a 5 year holding.
SBI Magnum MD Fund (NAV – Oct 2014) Rs.1,000
SBI Magnum MD Fund (NAV – Oct 2019) Rs.1,562
Capital gains at the end of 5 years Rs.562
Index value for FY 2014-15 240
Index Value for FY 2019-20 Rs.280
Indexed cost of acquisition (1000x(280/240) Rs.1,167
Indexed capital gains Rs.395
20% tax on indexed gains Rs.79
Effective tax rate on acquisition cost (79/1000) 7.90%
 
That is the real big advantage to an investor in these medium duration funds. Not only are the returns higher by 200 bps in pre tax terms, but the effective rate is just 7.9%.
 
What should you be doing?
Clearly, short to medium duration funds work best when your time frame is 3-4 years. You can still park your emergency funds in a liquid fund but the funds you don’t need immediately will be better off parked in a short to medium duration fund than in a bank FD. As the RBI cuts rates further, this performance gap will only widen. It is time to seriously look at shifting from bank FDs to medium duration bond funds. Keep it simple!

Related Story

Open Free Demat Account (Rs699)