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Debt Mutual Funds: Can They Still Provide Better Returns Than Bank Deposits or Direct Bond Holdings?

Now that you are done with quickly deploying money in debt mutual funds in last few days of FY 2022 - 2023 to take advantage of indexation benefits which stand withdrawn from 1st April 2023 onwards, what would you do with any money coming your way which you do not want to put in growth (risk) investments like equities?

If you go by news, the money would move back to bank deposits now that fixed income investment area has been tax-levelled. We’ll see in a while what numbers say. Though for me, bank deposits beyond the insurance amount are a strict no. That said buying GILTS from RBI Retail Direct portal does deserve a serious thought now.

But first let’s look at some subjective benefits of keeping money in bond funds. I could think of two:

-          Liquidity. Bond funds are very liquid, while I cannot say for sure whether direct government bonds will be that liquid as I have never sold a GSEC in secondary market. In fact, not bought any in Gsec secondary market too. And retail market for government bonds will take time to develop to ensure similar liquidity as equity markets. Bond funds have a distinct advantage here as of now, though I feel government bond market liquidity will improve going forward if more and more people log on to RBI retail direct portal and start owning government bonds directly.

-          Administration: Direct bond holdings will pay periodic interest in bank account. If one doesn’t need to money, this presents administrative (and discipline) issues of ensuring not spending the money and reinvesting it quickly. When one invests through bond funds, one doesn’t see the interest money in bank account and the process of reinvesting goes on mostly uninterrupted

I see above as good enough reasons not to totally abandon bond funds. But then, let’s also bring in some objectivity and see whether bond funds still offer reasonable enough numerical advantage over direct bond holdings. With indexation benefits out, tax deferral is the only benefit which comes into play. Total benefit accrued will depend on three factors

-          Investment horizon. The higher the period of uninterrupted holding, better the outcome will be as deferred tax benefits keeps on compounding

-          Bond funds tracking error, a large part of which will come from funds total expense ratio

-          Individual’s current income tax rate and terminal (withdrawal) period tax rate. This by far will may turn out to be the most significant factor

 

My workings show if:

-          Your current and terminal marginal income tax rate remain same, one would need to have horizon of nearly 25 years to realize significant benefits of going the bond fund way. Significant means (no logic, just my way) terminal corpus via bond fund holding route being higher by at least 10% than through direct bond holding. 25 years is way to long investment horizon

-          Your terminal marginal income tax rate is two notches below your current marginal income tax rate. Say you are in 30% bracket now and post retirement, your tax bracket will be 10%. Bond fund investment horizon of nearly 10 years will do the job in such a situation

Effectively, on the numbers side, benefits have now gotten slightly tricky and need individualized “predictive” ability of terminal tax rate. Long term holdings can still get sizable benefits provided one is deft in managing redemptions as per his / her taxation situation. A lot depends on this. Too much hassle some would say. But nobody said making money was an easy game.

As for my money goes, I am in a very nice situation – most of my non equity money is already in bond funds. So this taxation change doesn’t hit me that bad. But for any additional non equity designated funds, I will probably go by following rule of thumb:

-          Upto horizon of 5 years, direct government bond holdings is the way to go

-          5 to 10 years horizon – some part, say 25% to 50% maybe directed to bond funds. I hope MF houses reduce TER for government bond funds to keep the game going for them. And us too

-          Beyond 10 years horizon: Large part, maybe even 100% be directed to bond funds

Don’t forget, each to their own. What works for me may or may not work for you.

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