With Falling FD Rates, Debt Fund can offer better returns

The Corona Virus Pandemic did bring various challenges for the global economy. Similar to the approach taken by the central banks across the globe; India’s Central Bank, The RBI actively monitored the situation and drastically reduced the repo rate. While this move helped bring the borrowing rates down; there was a second-order effect of this. With the borrowing rates, the deposit rates were also slashed by all the banks. Hence, a lot of investors are now getting sub-par returns on their bank deposits. What can investors do to get better returns at a similar risk? In this blog, we will look at alternate options for traditional bank deposits in detail.

How the FD Rates have dropped

The RBI Repo Rate and Bank deposit rates are positively correlated to each other. It means that if the RBI reduces the repo rate, Banks also have to reduce deposit rates. This is because the bank’s interest income goes down with the repo rate. Back in January 2014, the 1 year FD rate of SBI was 9%, and after the revision on 10th Sep 2020, the new 1 year FD rate of SBI is 4.90%. Here’s how the Repo rate and 1-year SBI FD rates have moved over the last 7 years:

Returns are a relative phenomenon and when looked at in comparison give more clarity. The CPI inflation data released for August 2020 put the retail inflation at 6.69%. The current 1 year FD rates are lower than the inflation rate. This implies that investing in FD at this rate is generating negative real returns.

One of the important reasons for such low returns is also because of almost non-existing risk. We say almost because, in the public sector and bigger private sector banks, there is no risk in fixed deposits. However, in PMC like corporate banks, there is some risk that is masked by higher returns. Lower or negligible risk also leads to sub-par returns. One way to deal with this and to generate better returns in investing in market-linked debt products like Debt Mutual Funds.

Debt Mutual Funds can substitute Bank FDs if invested in the right way

Debt mutual funds in India have faced a lot of heat after the Franklin Templeton debacle. However, that was an isolated incident and it was a result of higher risk exposure in the underlying portfolio of the debt funds of Franklin Templeton. But if the debt mutual funds are selected carefully with proper due diligence, they will definitely be able to beat Bank FDs with a very little increase in risk.

Selecting the right debt fund is purely a function of the investment horizon. The mutual fund regulator Sebi has categorized the debt funds based on the duration of the underlying portfolio. And the funds that are most useful for more than 80% of the investors fall into 5 major categories :

Based on your investment horizon, you can select the category and subsequent fund from the category. We have taken category average returns into consideration which includes the best and the worst-performing fund from the category. Even with the category average, these funds have beaten the FD rates comfortably.

But what about risk? How risky are Debt Mutual Funds?

The additional return in Debt mutual fund does come at some risk. But this risk can be navigated properly to get the benefit of the return. Debt mutual funds have two major risks associated with them: Credit Risk, Interest Rate Risk. So while selecting the funds, you need to look at underlying credit quality. The portfolio credit rating should be AAA dominant and the portfolio duration should be in line with the investment horizon.

One important piece of advice on investing in debt funds is “Do not let the instances like franklin discourage you from investing in debt funds”. Debt mutual funds if managed properly can be an excellent solution and alternate for FDs. However, if you do not understand the risk exposure and cannot analyze the portfolio in detail, take the help of your financial advisor and get a customized solution for your investment needs.