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%|
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%|
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!