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Income Funds Good Investment Option Now
With a rate cut likely in FY16, schemes that invest in long-term bonds can hand investors both interest income and capital gains
Is it a good time to start investing in long-term debt mutual fund (MF) schemes? While the Reserve Bank of India (RBI) on Tuesday kept policy rates unchanged, wealth managers are recommending clients to buy fixed income schemes that invest in long-term bonds such as dynamic bond and income funds because RBI is expected to start cutting rates in 2015-16.
Individuals should invest in growth option of dynamic bond funds with a timeframe of three years and more.
It may be crucial for investors to stay put in these products for at least three years if they want to avail of tax benefits. Starting October 1, the dividend distribution tax (DDT) on dividends declared by debt schemes of mutual funds will be calculated on gross dividends, which takes away the tax arbitrage it used to offer compared with fixed deposits. This makes investments in dividend option of debt mutual funds unattractive. Wealth managers advise investors to opt for debt schemes with growth option as there is a possibility to pocket both interest income and capital gains over three years in a tax efficient manner.
With lower inflation, structural positive liquidity, stable currency , lower current account deficit and improving government finances, we expect 10-year benchmark yield to be around 7% by second quarter of CY2016 as compared to 8.51% prevailing now.
When rates fall, bond prices rally .This will translate into capital gains for the schemes that invest in such long-term fixed income instruments. According to Value Research, an MF tracking firm, long and medium term gilt funds as a category has delivered 6.1% over six months ended September 29. Part of these gains is explained by the declining interest rates in the economy. The 10-year benchmark yield has been on the way down and is hovering around 8.51% after hitting a high of 9.1% on April 7.
Income funds are less volatile as compared to long-term gilt funds and one can remain invested for three years even if there are quick movements in interest rates.
Recently, investors who bet big on long-term gilt funds on expectations that RBI would start cutting rates incurred losses when the rates rose quickly and the fund managers had no option but to remain invested.
Dynamic bond funds offer some space to the fund manager. If the expectation of rates falling does not materialise, then the fund manager can consider shifting the portfolio to short-term bonds to protect the portfolio from losses.
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