Match debt fund maturity to goals

Last Updated: Sun, Mar 31, 2013 04:26 hrs

Debt funds are an area that most retail investors are not familiar with. But investing in debt mutual fund schemes have benefits, that other products in the debt space may not be able to offer. It is important to consider aspects like liquidity, tenure, post-tax returns, risk associated with the product, amount to be invested and others before putting together the debt portion of your portfolio.

Bank and company deposits, Public Provident Fund (PPF), small savings instruments and so on are normally the investment avenues of choice for most investors. They use these as these instruments have existed for long and are easy to understand. All these instruments give fixed returns, which is very comforting. However what investors of such instruments would find it difficult in terms of liquidity, taxation and inflexibility.

As financial planners, we find tremendous value in investments in debt mutual funds to tailor solutions to meet the needs of our clients.

Long-term investment needs
Long-term corpus building is an important part of the financial planning process. This corpus is to take care of retirement as well as other long-term goals like children's education, marriage, retirement home among others. As part of the asset allocation some portion will be in debt instruments.

Medium to long-term debt funds, including bond and gilt funds are good avenues, which have the potential to offer between 8-9 per cent over the long term. Currently, income funds are offering double digit returns, which may continue for some more time. The attraction here is that the tax treatment is benign, for investments over one year. Long term capital gains tax applies here, where indexation benefit can be taken advantage of. After this indexation, the actual tax incidence may be in the region of 4-6 per cent (assuming current levels of inflation). Hence, there is little difference between gross and net returns as opposed to most other instruments where the gross returns would match a debt fund return, but the net returns are much lesser.

Liquidity and other short-term needs
Liquidity provisioning is to take care of sudden increase in expenses, which may not be anticipated. By its very nature, these funds have to be available, at short notice. At the same time, the money should be deployed in a manner that it earns good returns. That is why liquid funds are a good option. Dividend distribution option was the best option for this purpose. But, now things have changed after the current budget and the dividend distribution tax stands at 28.30 per cent. This tax is paid by the mutual fund houses and hence indirectly the investor is paying for it. For a person in the highest tax bracket, this is definitely recommended or for retirees. For those in the lower tax brackets, growth option would be a better choice, as the taxation is on their marginal tax rates, which is lower.

There are some who are far more prudent in managing their finances, than others. In such cases, we find that such individuals do not access the liquidity margin for very long periods, stretching to years. In such cases, growth option is suggested, as beyond one year, one can apply indexation and the taxation incidence reduces. Such investors could also consider short- or medium-term funds. These funds may have an exit load for a certain period. But, since these are disciplined investors, the chances of them cashing out in the initial exit load period is limited. Hence, these investors could enjoy potentially higher returns, even on the liquidity margin.

Emergency funds
Contingency funds are created to take care of specific expenses that are anticipated, but their frequency or timing is not known. An example of this is a contingency fund for one's senior citizen parents, for healthcare. In this situation, it would be a better to invest in medium- to long-term funds or in actively managed debt funds in the growth option, as the requirement may not be immediate. This way these funds can earn a higher return as compared to ultra short-term funds or short-term funds.

Planning for near-term goals/payments
Here, near-term means three to six months like for paying your child's school fee in three months. Or to fund holiday expenses in the next six months and so on. In this situation, an ultra short-term fund may be a good option. However, if the provision comes beyond six months the provisioning can be done through a short-term funds. Even a medium-term fund can be considered if the tenure is beyond a year. One can also consider monthly / quarterly Interval Plans for requirements which has a fixed timeline. But, in these cases, one needs to cash out in the window period available.

Investments and planning for upcoming goals
Fixed Maturity Plans (FMPs) are a good option for those who want fairly stable returns, without market fluctuations and who strive for tax efficient returns as typically indexation benefit is sought. Hence, this can be a good instrument. Investment in FMP is usually beyond one year, due to which single, double or triple indexation benefit can be availed of, as applicable and hence is tax efficient. FMPs can also be used for provisioning or meeting short term goals as it matures after a tenure and directly comes into ones bank account.

As we have discussed, debt funds can be used in your portfolio for a whole range of planning. You need to understand and appreciate the instruments place in your portfolio and the value these add in financial planning.

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