Indian five hundred rupee banknotes are arranged for a photograph in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

The Mutual Fund Show: Do Recent Bets Gone Wrong Make Debt Funds Unsafe?

First defaults by Infrastructure Leasing & Financial Services and now mutual funds’ standstill agreements with Zee and Anil Ambani group promoters have underscored the risks of investments in debt schemes. But are these unsafe?

Vijay Mantri, founder and chief investment strategist, says no. “Debt mutual fund is a very good instrument traditionally, the screening of credit is done by a highly experienced team, and it provides investors with tremendous diversification, reducing risk of capital erosion in case of default by a company,” he said on BloombergQuint’s weekly series The Mutual Fund Show. “If one looks at performance of debt funds over a period of five or 10 years, they have outperformed bank fixed deposits.”

Citing three-year returns and better prospective returns versus fixed deposits, Mantri said investors across income tax brackets can invest in the debt funds for the next three years. "There’s no interim tax liability unless you trigger redemption."

With the new nature of standstill agreements that some of the asset management companies have entered with corporate groups, are investments into debt or credit funds safe?

In my opinion, the debt mutual fund has been a very good instrument traditionally and even today it is not a bad instrument. But if someone has a concern on what is airing in the market and they want to take a call, then a knee-jerk reaction may not be the right thing to do. I can tell what investors should do in a few steps. Firstly, they need to consult their financial advisers, sit with them and figure out. Look at their own mutual fund scheme in which they have invested and figure out if these schemes were exposed to any of these names. If the answer is yes, then figure out how much percentage of that scheme’s AUM is exposed to these names. Once you have that number, then you need look at what has been the exit load in these schemes. Suppose the exit load in that scheme currently with the investor is more than the exposure to these groups, then it doesn’t make any sense to take the money out. If there is no exit load or if the exit load is lower, then investor needs to take a call on what they need to do. There you need to keep in mind the tax consideration. If you are already in this scheme for more than two years, then waiting for one more year, the entire tax comes down from 30 percent to 10 percent. One needs to then take a call with the help of an adviser.

Would you explain tax benefit in debt funds?

Lets look at someone who is in a 30 percent tax bracket. Suppose you have Rs 1 crore invested in fixed deposits. After all the surcharge, the tax rate is around 34 percent. On Rs 1 crore, one is earning Rs 7 lakh as annual interest. Out of that, you need to provide 34.5 percent tax. For that, one needs to take out Rs 7 lakh. So, 1.07 crore minus the tax outgo, then the rest Rs 1.04 crore get invested for second year. On that, you compound 7 percent. Then, next year you need to provide tax and in third year you need to provide tax. Effectively, the Rs 1 crore you invest in FD, the net amount works out to be around Rs 1.14 crore post tax. So, Rs 1.22 crore net of tax after three years have become Rs 1.14 crore. If you look at the same number in debt mutual fund, and let’s assume what happened in the last three years will be replicated in the next three years too. There are no intermittent tax liabilities. In the first year, there are no tax liabilities because of the way the mutual fund has been structured. In FD you get interest and interest gets accounted every year in your annual return. In mutual funds, until and unless you trigger a redemption, the capital growth doesn’t become a part of your income. It doesn’t get taxed for three years, till you get the money out. So, the power of compounding of that tax portion which goes out in a fixed deposit is reinvested in a debt mutual fund. If you do a comparison between a debt mutual fund and FD, you will figure out that for a 30-percent tax bracket guy, mutual fund delivers an absolute amount around 50 percent, more than what an FD would have done for you. I am talking about a market in which we have seen all kinds of challenges.

How does one pick and choose the quantum of money that we should put in debt funds? Are there any high-frequency alarm bells that one should keep in mind while choosing debt funds?

Debt funds are much simpler to invest in. The first rule is to look at the average maturity of a debt fund. It will tell you the weighted average maturity for all the securities in a debt scheme. Suppose you are investing in a liquid fund and if the average maturity is 45 days, it means that all papers of that liquid fund have maturity of 45 days. After 45 days, new papers needs to be put in. Suppose your investment horizon is one-day to a three-month period, liquid fund is the right option available to you. Whenever you are investing, look at what is your investment horizon and then pick the scheme which is two-three months lower than the holding period. Suppose you are investing for a three-year period, then you need to figure out fund which have 2.6-2.9 year maturity and this information is available readily. Whenever you are investing in any debt product, figure out your investing horizon. It is not that for every cash flow you are clear that when do you need this money. If you are not clear, then liquid fund is the best alternate because it is a very efficient product. If you look at liquid return for the last one year, it is more than 7 percent. For five years, the liquid return has been more than 8 percent CAGR. If you see the 15-year track record, they have delivered 7 percent-plus return. If you are looking at the cash flow where you are not sure when you need it, then liquid is one of the best strategies to see.

A better alternative for somebody who is in a 30-percent tax bracket is to look at equity arbitrage fund, but your investment horizon has to be for a minimum three-year period. Post tax, equity arbitrage consistently delivers 0.5-1 percent more return than a liquid fund product.

Watch the entire discussion here