Here’s why its Time to shift from fixed deposits to debt funds

The expansion in the key benchmark rate, subsequent to holding it for an extensive stretch since May 2020, has prompted security yields ascending across maturities.

Here’s why its Time to shift from fixed deposits to debt funds
Here’s why its Time to shift from fixed deposits to debt funds

Over the past five months, RBI has been increasing repo rates—the rate at which the central bank lends to banks—and decreasing system liquidity. 

Bond yields have increased across all maturities as a result of the rise in the key benchmark rate, which has been in place for a considerable amount of time since May 2020.For instance, the benchmark 10-year G-Sec yields have risen very nearly 160 bps to 7.49 percent throughout the course of recent years.

As a result, debt funds have not performed well over the past two years as the prices of their holdings have decreased. This is due to the fact that debt mutual funds are required to mark their NAVs to market on a daily basis, so when bond prices fall, so does NAV. According to Sandeep Bagla, CEO of TRUST Mutual Funds, investors have withdrawn nearly Rs 2 lakh crore from debt funds this calendar year, and returns have generally been positive, ranging from 3 to 4 percent annually.

However, due to the rising bond yield-to-maturity, many experts recommend investing in debt funds. For instance, a class of debt funds known as Target Maturity Funds perform better than fixed deposits if one has a medium-term horizon (4-6 years), does not mind short-term fluctuations in returns, and is interested in post-tax returns.

Over the course of four to six years, Target Maturity Funds provide yields (net YTM) in the range of 7.25% to 7.25%.State development loans (SDLs), PSU bonds, and government securities make up the majority of their investments, which are held until the scheme's end.

If you think of them as open-ended Fixed Maturity Plans (FMPs), they make good investments because they have portfolios of high-quality bonds and the potential for better returns after taxes.Alok Aggarwala, Chief Research Officer of Bajaj Capital Ltd., states, "We are recommending investments into funds that have roll down or portfolio maturity of 2 years or less. The only caveat is that the investor shouldn't mind the temporary fluctuations in NAV."

It's possible that yields will remain higher and inflation will remain stubborn for a longer period of time.

According to Bagla, "at this point, we would advise only 5%-10% to longer-term funds, approximately 25% to liquid/money market funds, and approximately 65% to short-term funds or BPSU (Banking and PSU) debt funds with roll-down maturity of less than 2 years."
Additionally, debt funds outperform fixed deposits due to their tax advantage.

Investing in bond funds should yield a portfolio yield that is higher than that of fixed deposits when bond rates rise faster than bank FD rates.

Long-term capital gains tax with indexation benefit is required to be paid by investors who hold mutual fund investments for more than three years.

Because there are no tax advantages to holding 3-year deposits, debt mutual funds' post-tax returns may be significantly higher than bank FDs' post-tax returns, according to Bagla.
As a result, now is a good time to invest in debt funds if you want to capitalize on changes in interest rates.

For instance, in fixed deposits, whereas bank deposits have a low interest rate of 5.45-6.10 percent, certain AAA-rated corporate deposits have a coupon of 7% or slightly higher, making them an appealing proposition. This, in addition to the fact that they do not carry interest rate risk, explains Aggarwala.

Last but not least, choose based on risk profile, as higher interest rates come with higher risks.