If you think returns from bond funds will trump those from bank fixed deposits, you have another think coming
Moneylife Digital Team
The corpus invested by mutual funds in bonds is much larger—almost eight times—than in equities. Bonds should also be a very important part of your asset mix. So, are mutual funds that invest in bonds preferable to bank fixed deposits (FDs)?
The features of bank FDs are better known than the trends and performance of bond markets, especially when the interest rate scenario is volatile. This is because the bond market is practically closed to individual investors. If you want to buy, say, an 8.5% Government of India (GoI) 2020 bond, you will not be able to because it is not traded like the shares of Reliance in small quantities by millions of investors.
Bonds are sold in large blocks of crores of rupees, among large institutional investors like banks and corporate treasuries. But there is a way to participate in that market—through bond funds (also known as income funds). Bond fund managers are professionals who know which bonds to buy and when to offer you professional management of fixed-income securities.
The question is: How have bond funds performed vis-à-vis bank FDs? Is it worthwhile pulling out some money from FDs to put it into bond funds? The advantages of bond funds are well-touted—lower risk and steady income, in addition to liquidity of investments. During an economic slowdown, it is believed that bond funds tend to perform better than other investments. According to mutual fund houses, bond funds are considered better than FDs because bond funds provide the best opportunity to gain from interest rate movements.
However, before you decide to jump in, it is worth asking: How do these merits of bond funds and their performance stack up against FDs? Let’s evaluate the scenario since 2004. In 2004, out of 31 bond funds, 23 outperformed, seven underperformed while only one had just equated its benchmark—giving average overall returns of 9.27%, while the benchmark CRISIL Composite Bond Fund Index gave a return of 8.77%, and the one-to-three year bank FD rate for 2004 was around 5%. In 2005, out of 33 bond funds, 24 outperformed and nine underperformed. These funds gave an average return of only 1.12%; the CRISIL Composite Bond Fund Index gave a return of 0.04%—the FD rate for 2005 was around 5.4%.
Rising interest rates -
In 2006, out of the total of 37 bond funds, 24 outperformed and 13 underperformed. These funds gave a 4.14% return on an average, while the CRISIL Composite Bond Fund Index for the same year gave a return of 3.27% and bank FD delivered returns of 6.3%. In 2007, there were 38 bond funds of which 32 outperformed and six underperformed. These funds yielded average returns of 5.11% compared to the CRISIL Composite Bond Fund Index, which gave a return of 3.75%, and bank FDs delivered 8.3%.
In 2008, out of 39 bond funds 23 outperformed and 16 underperformed. These funds gave an 8.02% average return compared to the CRISIL Composite Bond Fund Index which gave 8.18% return, while bank FDs delivered 8.5%. Next year, there were 44 schemes of which 31 outperformed and 13 underperformed. These schemes gave an average return of 9.34%; the CRISIL Composite Bond Fund Index gave a return of 7.33%—and bank FDs delivered 8.4%. In 2010, out of 51 funds, 31 funds outperformed, while 20 underperformed. These funds fetched an average return of 5.62% compared to the CRISIL Composite Bond Fund Index which gave a return of 5.18%. In 2011, of the 63 funds, 39 funds outperformed and the 24 underperformed. These funds gave an average return of 5.72% compared to the CRISIL Composite Bond Fund Index which gave a return of 5.04%. Returns from bank FDs for 2010 and 2011 were 6.5% and 7%, respectively. Clearly, bond funds have never earned higher than bank FDs—except in 2004 and 2009.
The comparison is a bit tricky because comparison of all returns has to be on a post-tax basis. Equity mutual funds are tax-free and long-term capital gains on equity shares are also tax-free. But fixed income is taxed and at different rates for different instruments. Tax on income from FDs attracts the normal rate of taxation for individuals, while it is not so for bonds. Bonds held for over a year attract long-term capital gains tax. Plus, since it is an asset held for the long term, the cost is adjusted upwards to give indexation benefit to the holder.
Even adjusted for these tax breaks, bond funds don’t deliver a significantly higher return. This means that there is no need to pull out money from FDs and put it into a bond fund. But the bigger issue is that the principal in an FD is risk-free and return is non-volatile. But the return from a bond fund can go down sharply, if the bond fund manager does not time an interest-rate cycle properly. Even the best of bond managers have their ups and downs. There can also be a situation that you need money exactly at the time when the fund is down. You may have to withdraw your money against your wish. So, while a particular bond fund may sport a five-year return of 9%, your effective return may be lower, if you cannot hold on for five years at a stretch. But the return from an FD won’t create a dent in your pocket. An FD with major scheduled banks is practically zero-risk and liquid. You can take out the money whenever you want to.