What returns should you expect from your debt funds?

Please note that debt fund taxation has changed with effect from July 2024. Please refer to this article for updated tax rules.

The last two years of turmoil in the debt fund space may have left you wondering what returns to expect from debt funds. Will debt funds beat FD? Or would their returns hover somewhere around their yield (yield to maturity) as promised by some? Are double-digit returns possible in debt? We try to provide answers to these (and bust some misconceptions in the process) by analyzing data across those debt fund categories that are popular among investors.

We analyzed past data – including a rate increase (not a high one) and rate decrease period and included one of the worst periods (last 1 year) for debt in terms of credit defaults – thus, broadly covering scenarios that impact debt returns. We took 1-year returns rolled daily for the past 3 years (spanning 4 years) and 3-year returns rolled daily for the past 5 years (spanning 8 years). It is noteworthy that when we talk about averages. That means there could be periods of higher or lower returns than the average. And there could be funds with higher or lower returns than the average mentioned.

Use this analysis to set more realistic expectations from debt funds instead of a vague 8% or 9% return you may have in mind.

Reality in the short term

Had you locked into 1-year FDs between 2015-19, you would have got an interest of 7% on an average (pre-tax). Now look at table 1 below: The average returns of the various fund categories might seem to suggest that you managed this return with debt funds as well. But not really.

• None of the fund categories steadily
  managed to beat FD returns (6.9%) over 1-year periods. In fact, most of the
  times, funds did not manage above 7% returns over 1-year time frames (see the
  row ‘% of times >7% in table 1).
• Low-volatile, low duration funds
  such as liquid, ultra-short term and partly short duration funds managed over
  6% returns almost all the time. But the other categories, which are either
  volatile due to interest rate movements (dynamic bond, corporate bond, gilt) or
  have credit risk struggled to generate 7% returns steadily over 1-year time
  frames.
• The minimum returns column will tell
  you how worse it can get in each category. You will see that categories such as
  gilt, dynamic bond or credit risk have declined or remained flat over shorter
  time frames. 

Please remember, for less than 3-year periods, there is no tax edge (unless you do a SWP). So, looking at pre-tax returns is important.

Table 1- 1-year returns rolled for 3 years

Period ending Oct-19. 1. Ultra short includes floater, money market and low duration. 2. Short duration includes banking & PSU debt. 3. Gilt includes constant maturity

Takeaway: In the short term, only liquid and ultra-short term debt funds appear to provide you stability and decent returns and very importantly provide liquidity. The other categories only add to your risk level without compensating you with consistently adequate returns and are not meant for short-term holding.

Reality over the long term

 Now let us take the 3-year returns (Table 2). This data is for 3-year time frames over 2011-19. Over this period, if you had simply been rolling your 3-year deposits, the average interest that major banks gave you would have been 7.2%. Compared to this, the 3-year returns of funds given in the table do seem superior (table 2). Also, with the indexation benefit (over 3 years) kicking in for long term capital gain, the post-tax returns would have been even better. But here are some reality checks from the data:

1. Over longer periods, the ability of funds to generate 8-percent plus returns was not high. While the credit risk category scored the best in this, this category can also deliver very low returns (see the min. returns row) if your fund was hit by a default or by several downgrades.

Table 2:  3-year returns rolled for 5 years

2. The graph below will tell you that categories such as liquid, ultra-short and short duration were less volatile and their decline in returns over the years was linked to gradual rate decline alone. Categories such as gilt and dynamic have been more volatile, reacting more to rate changes. Credit as a category can be low on volatility but one-off defaults can entirely pull down the returns from one to zero in no time.
3. Double-digit returns are temporary in interest sensitive categories (gilt, dynamic bond) and are not the norm. Gilt funds, for instance, managed over 10% returns only 40% of the times in this period. If you had been lucky to enter (and exit) you would have locked into such returns. Else, they tend to return to normalcy soon.

Takeaway: Funds stand a far higher chance to outperform FDs (with higher risks that is) over 3 years or more. Also, the taxation benefit provides a superior post-tax return. However, sustained periods of over 8 percent returns is hard to get even over long term. What you should look for, if you are in the 20-30% tax bracket is superior post tax returns over FD without high risk. This leaves you with either low volatile categories such as liquid/ultrashort/short even for longer time frames or take some volatility to go with gilt/dynamic bond or corporate bond categories.

Yield and returns

Yet another expectation of return stems from many of you being sold products stating that the yield to maturity (the yield of the instruments in a fund’s portfolio, if the instruments are held till maturity) of a fund minus the expense ratio is the returns you can expect in an accrual fund. For example, if an accrual fund had a YTM of 8% and expense ratio of 1% and the portfolio’s average maturity was 2 years, the returns of the fund was promised as 7%. We took the credit risk category, where this kind of return expectations were set the most in the past few years. Now let us see the data below.

As per the YTM promise, your returns should have been 7.2% (YTM minus expense ratio) at least. But thanks to the credit turmoil, it is at 3.4%.

Worse still, there are funds that sport over 12% YTM now, more from non-receipt of dues than from any real return. The bottom line is that YTM does not automatically translate into returns, especially when risky events play out.

At PrimeInvestor, we try to optimise return and risk when we pick funds. Credit risks are a strict no in the short term and are kept minimal even for the long term. We do not shy away from telling you when you should stay away from debt funds and are better off with other fixed income options. When we build portfolios, we take the best in debt across personal finance categories. If a fund won’t do for certain goals or needs, we won’t add it for the sake of having a mutual fund. We may suggest a deposit or government scheme too. Stay tuned for our all-product portfolio that will ensure you choose the right products for the right goals.