Are fixed income funds better than traditional fixed deposits?

I  believe this is the right time to explore the scenario of falling interest rates and take a prudent look at alternative investment avenues to bank fixed deposits. Historical data provides evidence on how in a falling interest rate environment, fixed income funds have performed better than FDs.

Over the last year-and-a-half, the RBI has been following an accommodative monetary path, adding liquidity and reducing policy rates.  An economic environment with low demand led to declining interest rates; while the government’s historic decision of demonetisation has channelised cash into the banking system. Evidently, surplus bank liquidity and low interest rates are here to stay.

So, how does one deal with a falling interest rate scenario and are there any alternatives? Whenever there is a sharp movement in interest rates, it’s the fixed income portfolio that needs restructuring. Take the current scenario: though a decline in lending rates is good news for home loan buyers, a decline in FD rates are a cause of worry.

With rates for deposits falling to below 7%, retail investors are feeling the pinch. As FDs lose their sheen, investors must look at alternatives. While depositors are somewhat disheartened by this fall, let’s remember India is one of the few countries that offer an attractive real rate of interest.

While equity mutual funds are more glamorous and get written about often, fixed income funds have attracted sizeable investments. Over the last 16 years, fixed income constitutes about 65% of the MF industry with AUM of Rs 10.75 lakh crore, nearly two-thirds of this industry’s total assets of Rs 16.46 lakh crore.

*Time to urge investors to consider fixed income funds

* Fixed income funds have delivered fairly attractive returns as on December 30, 2016.

Eventhough nominal interest rates appear low from a historical perspective, the real rate of returns adjusted for inflation are indeed at the upper end of what it had been in the last 10 years.

The core allocation to fixed income should be done keeping in mind the investment horizon and risk appetite. Most investors will find Credit Opportunities Funds an attractive investment category for their medium-term needs.

This category has historically delivered around 200 basis points over FDs. With complete flexibility on withdrawal and tax benefits for over three years, the returns from fixed income become even more attractive. As an investor would I not look to restructure my debt portfolio for efficiency and better returns? 

*So why are fixed income funds able to deliver higher returns than bank deposits?

The MF industry has the lowest cost of intermediation amongst financial services. As against the Net Interest Margin (NIM) of the banking sector tends to be over 300 basis points, the MF industry operates on a significantly lower expense ratio.

From a credit perspective, unlike banks, MFs operate in a different credit space. Most of the portfolio of the MF industry is rated above investment grade. At a time when the banking sector’s Non Performing Assets (NPAs) are touching alarming levels, MFs continue to have a pretty good portfolio quality.

Traditional FDs

Investors with a shorter time horizon will find ultra-short term funds a good option when compared with traditional FDs. For those who are not worried about liquidity, it is close-ended funds or Fixed Maturity Plans (FMP). Even as investors fret over falling yields on fixed income instruments, MFs have the ability to position themselves to benefit from falling interest rates, particularly by skewing the portfolio towards longer maturity papers.

They also offer significantly lower taxation. For investors holding schemes for three years or more, these schemes can take the benefit of lower taxation under LTCG (Long Term Capital Gain).

This can effectively bring down the taxation to 10-15%, thereby yielding much better post-tax returns for investors in higher tax brackets.

(The writer is CEO at DHFL Pramerica Asset Managers)