Bonds over FDs

If you are a debt investor content with putting money into fixed deposits ( FDs), this might be a good time to consider duration funds. The Reserve Bank of India ( RBI) surprised the market last week by cutting the repo rate by 25 basis points (bps) to 7.75 per cent. If interest rates fall further by about 50 to 75 bps, as is widely expected, long duration bond funds will rally. That's because bond prices rise when interest rates fall, meaning bond investors will benefit from capital gains in addition to interest income. The longer the average portfolio maturity of a bond fund, the higher the capital appreciation when rates fall.

Bond funds score over fixed deposits in two ways: tax treatment and superior returns. If the holding period is three or more years, bond investors are taxed at 20 per cent with indexation, whereas interest for FD investors is added to their income and taxed in line with their individual slab rates of 10, 20 or 30 per cent. Investors in the 30 per cent tax bracket especially stand to benefit by choosing bonds over FDs.

Two to three- year FDs will fetch you around 8.5 per cent pre- tax. On the other hand, assuming a rate cut of 50 bps over the next one to one- and- a half years, duration funds of six- seven years will give effective returns to 11- 12 per cent over the next one to two years. This includes capital gains of three- four per cent plus accrual income of around 7.7- 8 per cent.

Investors can look at three different categories of long- term bond funds. Gilts, income funds and dynamic bond funds. Of the three, experts believe dynamic bond funds can be more suited to investors' needs, as fund managers have the flexibility to change duration depending on the interest rate outlook. Income funds and gilts don't have this luxury.

Income funds are better than gilts, as they are less volatile and invest in corporate bonds, apart from government securities. Gilts are ideally suited to savvy investors or traders who are more interested in taking short- term calls.  Income funds can also gain if the spreads between corporate bonds and government securities reduce.

Investors should aim to hold these funds for at least three years, to ride out the inherent volatility. With duration, there could always be short- term volatility and therefore there is a need to hold for a longer period to ensure returns are captured, especially when one is looking at capital appreciation opportunities when rates fall.

Long duration bond funds have emerged the top performers among debt funds this year. According to data collated, gilt medium & long term funds and income funds have given one- year average category returns of 16.5 per cent and 13.4 per cent, respectively. The yield of 10- year government papers has fallen to 7.69 per cent from 8.5 per cent last year.