Long-term view

Written by Saikat Neogi | Updated: Aug 13 2013, 21:55pm hrs
At a time when investors were gradually moving toward debt funds, the spike in yields since July and the hike in dividend distribution tax (DDT) since June have come as a double whammy. In July, the assets under under management of mutual fund companies in the debt fund category (liquid funds) fell by Rs 45,296 crore, or 21%, as compared with June, to R1.29 lakh crore because of large-scale redemption following the liquidity-tightening measures taken by the RBI to strengthen the rupee.

Bond yields and returns on debt funds move in opposite directions as bond yields rise, returns fall and when the yields fall, returns rise. The liquid funds category, represented by Crisil-Amfi Liquid Fund Performance Index, gave 0.27% returns in July as the 10-year government bond yields surged over 70 bps during the period

From June, dividends declared by debt-oriented mutual funds for individual investors attract a uniform rate of DDT of 25% (plus surcharge and cess see graphic). The DDT on debt funds for individual investors or Hindu Undivided Family (HUF) has now been hiked to 28.325% (25% + surcharge + cess), while for investors in fixed deposits who are in the highest tax bracket, the applicable tax rate is 30% + surcharge (if applicable) + cess.

So, will the new DDT rate make the dividend option in debt funds less attractive for individuals

Dhruva Raj Chatterji, senior investment consultant, Morningstar Investment Management, says the recent hike in DDT for individual investors in debt funds has made the dividend option of these funds less attractive than before. However, if you are in the highest tax slab of 30%, the dividend option still provides better post-tax returns than avenues like fixed deposits. Also, if you are investing in a debt fund with an investment horizon of more than one year, it makes sense to go for a growth option, as the long-term capital gains tax on debt funds is 10% (plus surcharge and cess) without indexation, or 20% (plus surcharge and cess) with indexation, he says.

Investors may consider the growth option to negate the hike in DDT. The move from dividend to growth option is purely a factor of yield maximisation, and if the investment horizon is in excess of a year, the preference for growth option should be considered, says Brijesh Damodaran, founder and managing partner of Zeus WealthWays LLP.

If you are in the highest tax bracket and your investment horizon is less than a year, the dividend option should be the one. Also, if the investment is for a longer term and one needs a regular income, the investor can switch to the growth option with a Systematic Withdrawal Plan, which allows for periodic withdrawal of the corpus, says Damodaran.

Also, after the spike in bond yield and the hike in DDT, does it now make sense for individual investors to look at bank fixed deposits Damodaran says bank fixed deposits definitely have a place in the investment portfolio. The one-off, one-day move to value the liquid funds NAV on marked-to-market has increased the importance of fixed deposits. For an investment horizon of 0-30 days, an investor who cannot take any risk on capital, fixed deposits can be in the portfolio and if one is looking for a constant income stream, then fixed deposits should be part of the portfolio as an asset allocation strategy, he says. However, he also emphasises that if the investment is for a longer period, then debt mutual funds score over bank fixed deposits in terms of post-tax yield.

Analysts say investors should not mix long-term and short-term fund requirements and clarity on time horizon is important while investing in debt funds.

Investments in bonds must be carried out with asset allocation and time horizon in mind. In fact, an a note last month, Morningstar's Chatterji wrote that the sell-off seems to be quite extreme, and too quick. It would be advisable for existing investors, especially those who have got in the last couple of months, not to panic and sell off in a hurry, as they could be exiting at a loss. They should wait for the dust to settle and the rupee to stabilise a bit before taking a decision, he cautioned.

Analysts say over time, debt as an asset class works well and builds up a strong portfolio. Despite the current volatility in the debt, the allocation towards debt should not change much and the portfolio must be maintained as per the near-, medium- and long-term needs of the investors. Any sudden positive measures or reversal of the current ones can lead to a similar reversal in yields downwards. Hence, gilt funds can also be looked at from a short-term tactical point of view.