Do you prefer bank term deposits or debt mutual funds?
Bank FD offers higher security, zero volatility and guaranteed returns. Debt funds, on the other hand, offer more tax-effective returns.
Now suppose you’re not interested in Bank FDs and Debt Funds, and prefer the one that is likely to give you a better return.
And how do you find it?
A common method is Compare the current 1-year bank FD rate to the 12-month return of a debt mutual fund.
However, that’s not the right approach. This post will explain why. So if that’s not the right approach, what do you compare 1-year FD returns to?
Before we get there, a quick comparison of bank FDs and debt mutual funds
Bank FDs and Debt Mutual Funds
safety: Bank fixed deposits are as safe as any investment. Choosing the right kind of debt fund can reduce your risk, but debt funds don’t give you that kind of comfort.
Predictability of returns and volatility: The bank’s FD also scores here.
If you have a fixed deposit with a bank, you can be assured of repayment. You can fix your interest rate. No volatility.
Debt fund with no repayment guarantee. Returns (or YTM) cannot be locked. Target maturity funds (TMFs), like debt funds, come closest to locking in returns. However, even TMF can be highly volatile.
taxation: This is the area where debt funds score higher than bank FDs.
Interest on FDs is taxed at the slab rate. This becomes a problem when income tax rates are high. Debt funds are exempt from taxation if the holding period exceeds three years. Benefit from indexing and be taxed at a reduced rate of 20% (after indexing).
If you can’t compromise on safety and return predictability, FD is the clear winner.
However, if you expect risk and volatility for more tax-efficient returns, debt funds may be an alternative.
Interest rates have risen in the last six months.
When interest rates rise, two things happen.
#1 Bond prices fall This is because bond prices and interest rates are inversely related. And because debt mutual funds hold bonds, Debt fund NAV also droppedAnd when NAV goes down, past performance gets worse. It also underperforms returns over the past six months or one year.
#2 But expected (future) returns go up. Bonds pay fixed coupons (interest) at regular intervals and mature at their par value. Coupon and face value do not depend on the price at which the bond was purchased.
Therefore, if you can buy a bond cheaper than Investor A, you will get a higher return than Investor A (if both hold the bond to maturity).
Investor A: Buy a bond at Rs 100.
Suppose interest rates rise and the price of the same bond drops to Rs 90. You buy a bond at Rs 90. Both win the same coupon and get the same denomination at maturity.
But you paid 90 rupees while Investor A paid 100 rupees. So you get a better return because you paid less on your bonds.
Therefore, when interest rates rise, debt fund returns fall, but expected returns rise.
How do you estimate potential returns?
A debt mutual fund’s (or bond’s) yield to maturity (YTM) is the best indicator of future returns.
YTM definition reproduced from Investopedia.
Yield to Maturity (YTM) is the expected total return on holding a bond to maturity. Yield to maturity is considered a long-term bond yield, but expressed as an annual rate. That is, the internal rate of return (IRR) of an investment in a bond if the investor held the bond to maturity, made all payments on time, and reinvested at the same rate.
Read: Which mutual funds are best when interest rates are rising?
But YTM also has problems
YTM is a reliable measure of return for bonds if you hold them to maturity. This is because bonds have a finite lifetime. There are no holding costs and the cash flow from the bond is completely predictable.
YTM is also fairly reliable against Target Maturity Funds (TMF) such as Bharat Bonds (if held to maturity). These products have an expiration date and an associated maturity date. For example, Bharat Bond 2025 will mature in April 2025 and Bharat Bond 2030 will mature in April 2030.
Portfolios of such funds, by design, do not require much churn. The bonds in the portfolio are designed to mature close to the maturity date of the product. Therefore, there is little risk of reinvesting the principal. However, costs, tracking errors, and risks associated with reinvesting coupons from the underlying bond may result in differences between YTM and actual returns.
Not as reliable as other debt funds. Most debt funds have an infinite lifespan. Therefore, there is no concept of maturity. Our portfolio is constantly changing. The bond matures and a new bond replaces it at the current yield (coupon). Both principal and coupon are subject to reinvestment risk. There are cash inflows and outflows. Additionally, your return will depend on the trajectory of YTM, the rate at which the maturing bonds and coupons are invested, the cost of the fund, and the general yield at exit from the fund.
YTM is not as reliable a metric as the 1-year FD return, but it is much better than the past 1-year return.
warning: Rise in interest rates. His NAV of bond prices and debt funds fall. YTM rises. However, interest rates can always rise further. In that case, bond prices and debt fund NAVs would fall further. It hurts more. Past performance has deteriorated further. And YTM (or potential revenue) will go up even more.
This can also happen in the opposite direction. Interest rates go down. His NAV of bond prices and debt funds rise. YTM fell. However, if interest rates drop further, YTM will be even lower. And bond prices and debt fund NAVs will show even higher returns.
What’s the problem in comparing the 1-year FD rate and the debt MF return after 12 months?
The 1-Year FD Rate is the return you will get over the next 1 year.
A debt mutual fund’s historical (trailing) 12-month return shows how much it has earned in the past year.
The 1-year FD interest rate is a forecast. This will give you an idea of how much you will earn over the next year.
One year of debt repayment is retroactive. You never know how much you’ll make in the next few years.
So it’s not correct to compare these two, is it?
A correct comparison should be made with YTM.
Let’s look at the examples in this section.
If interest rates have fallen in the past year
If so, the FD interest rate is likely to fall by the end of the year as well. So if 12 months ago at 6% p.a. So compare the competition to this 4.5% pa.
In the same interval, bond prices rise due to falling interest rates. Debt fund NAVs will also rise, positively impacting short-term returns. But that is in the past. Past year returns don’t tell you what to expect in the next 12 or 24 months. To do that, we need to focus on YTM.
After the first wave of Covid (March 2020), something very similar happened. The RBI has sharply cut repo interest rates. The FD interest rate also plummeted. Debt funds will benefit from this.
March 2021comparing 1-year FD returns with 12-month debt fund returns, the latter looks more convincing (capital gains due to falling interest rates).
At that time, the FD rate was about 5% per annum. This was frustrating for investors. A number of clients have inquired about comparing the FD rate to his 12-month return on a debt fund (shared by RM). Debt fund returns over the last 12 months have been impressive (due to lower interest rates).
However, the debt fund YTM has significantly underperformed its returns over the last 12 months. YTM is also lower because it reflects the general yield of the economy.
So let’s see what happened in the next 12 months. From March 31, 2021 to March 31, 2022.
As you can see, YTM proved to be a better indicator of returns over the next year, especially for short duration funds. In fact, 1-year FDs have outperformed most debt funds over the next year.
For the FD rate, I This publication from the Reserve Bank of IndiaThe RBI shows data for a period of 1-3 years, but I take the FD rate floor. The 3-year FD rate is likely to be higher than the 1-year FD rate.
If interest rates have risen in the past year
In that case, the FD rate may be higher than it was a year ago.
So today you can open FDs at 6% per annum, whereas about a year ago you could only open at 4.5% per annum. Comparing competitive products to 6% pa.
Interest rates are rising now, and debt funding would have suffered because of the rising interest rates. So the recent past performance is also worse. By the way, the negative impact of rising interest rates is greater for funds holding long-duration bonds (compared to debt funds holding short-duration bonds).
Well, let’s go back to November 2021. Interest rates have been rising for the last 12 months (November 2021 to he November 2022).
Here we see some discrepancies between YTM on 30/11/2021 and liquidity and overnight fund returns over the next 12 months. The reason is that these funds hold very short-term securities.
Overnight (1 day) and liquid funds (up to 90 days). Portfolios change rapidly. Bonds mature and exchange. These funds therefore benefit because their reinvestment occurs at a higher rate.
What’s your rank today?
Interest rates have been rising over the past six months, which could have a negative impact on debt fund returns. However, his 1-year FD rate is rising. SBI offers his 1-year FD at 6.1% p.a.
Returns over the past 12 months have been poor for a debt fund, but YTM should be on the lookout. As the rate went up, so did the YTM.
1-Year FD Rate > Past 1-Year Return of All Eligible Debt Funds.
But as discussed, YTM should be the focus.
If you’re worried about interest rates rising further (whether or not they happen), go for a short duration fund, or if you want a fixed yield, you can consider a target maturity fund. See this post for more details.
don’t come to the wrong conclusion
I’m not saying that debt funds are better than bank FDs at this point (December 2022). Both have their own strengths and weaknesses.
I trust your judgment
I just want to highlight two aspects.
- When comparing a debt fund to bank FDs, don’t focus on the trailing return of the debt fund.Or while comparing two debt funds. You could be going in the wrong direction. This is also true if you are choosing a debt fund.
- Focus on YTM (Yield to Maturity)YTM is not failsafe, but it is the best indicator of potential returns from debt funds, especially for short duration debt funds.
Regarding short-term performance projections, YTM seems to be a more reliable indicator for short duration funds (overnight, liquid, ultra short, low duration and money market). These funds typically hold bonds with maturities of one year or less. This is because such funds are less sensitive to interest rate movements.
A longer maturity bond fund (SBI Constant Maturity Gilt Fund) is more sensitive to interest rate movements, so unless you have a view on interest rate movements (and I know you are right), short-term returns are becomes difficult to estimate. By the way, YTM is also a good predictor of long-term bond fund returns if you hold the fund for a long period of time.