Bank FD rates have gone down sharply. What should you do?

You must learn to live with it.

And I concede FD rates have gone down sharply. I copy the current FD rates from the SBI website.

A common refrain is, “Fixed Deposits are giving nothing. I want to invest in debt mutual funds to get a better return”.

Why?

Because when we compare past 1-year returns of a debt mutual fund with the current 1-year Fixed deposit rates, debt funds look better. This is a wrong comparison.

Though, not completely correct, a much fair comparison is between current Yield-to-Maturity (YTM) of a debt fund scheme and the 1-year fixed deposit.

This is because YTM (less fund expenses) is a better indicator of prospective debt mutual fund returns than past 1-year returns. In fact, past 1-year returns are quite useless for debt MF schemes.

We have to choose an investment for the next 1-year (or any other duration). 1-year FD rate tells you how much you will earn if you invest in the FD for one year. Though not exactly the same, YTM of a debt MF schemes gives an indication about your future returns from this investment.

What is Yield-to-Maturity (YTM)?

I reproduce the definition of Yield-to-maturity from Investopedia.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Now, let’s extend this definition to mutual fund portfolios (in the context we are discussing). Let’s assume an MF scheme were not to accept (or make) fresh investments, disallow redemptions, and were to return the money to investors as and when it is received from the borrowers. It does this until its portfolio gets exhausted. In such a case, YTM is the return that the investors will experience from this day onwards. Or if you were to put down cashflows in an excel sheet and use XIRR function to calculate return, it will give you YTM. I have considered that the expenses (expense ratio) are zero. Expense ratio will bring down net returns lower.

You might argue that your fund is not closing redemptions and purchases. However, even in that case, YTM is the good estimation of returns. I will discuss why.

Let us consider a 10-year Government Bond that pays an annual coupon (interest) of 8% p.a. The face value is Rs 1,000. Not matter how you spin it, the bond will pay Rs 80 in annual interest for 10 years and Rs 1,000 at the time of bond maturity. Hence, the total payment from this bond will only be Rs 1,800 (Rs 1000 + Rs 80 X 10). If you bought at auction at par and held the bond until maturity, you will get Rs 1,800 over the next years. Not a rupee less, not a rupee more.

However, after a few years, if the interest rates goes up suddenly from 8% to 6% p.a. The new bonds issued by the Government will be at yields of 6%.  The older bond with the coupon of 8% from becomes precious. Hence, its market price will increase (or the bond yield will fall). Let’s say its price goes up from Rs 1,000 to Rs 1,100. And the mutual funds that are holding such a bond will experience a more than usual rise in NAV.

At the same time, if a new investor buys this bond at Rs 1,100 and holds it until maturity, his net return (XIRR) will be only 6% p.a. (even though the coupon remains 8%). Moreover, the new investments that the fund makes will be made at lower yields (since the interest rates have gone down). The twin effect is that the yield-to-maturity of the bond/debt MF portfolio will go down (even though it has recently shown a jump in NAV).

I understand it is not an easy-to-grasp subject. If you are confused, remember the classic relationship between interest rates and bond prices.

When the interest rates down, the bond prices go up.

When the interest rates go up, the bond prices go down.

And the interest rates have gone down in the recent past. Here is the 10-year Government Bond Yield chart.

Over the past 1 year, the interest rates have gone down which has resulted in good returns for many debt mutual funds (especially the ones that held longer maturity bonds). However, those returns are for the past.  For future returns, YTM is a good indicator.

You can again argue that given the economic scenario (low growth and inflation), there is a chance that interest rates can go down further (I believe so too). And this (given the classical relationship between bond prices and interest rates) will boost returns for debt mutual funds. I do not deny that is possible. But we must remember this relationship works both ways. If the interest rates were to go up instead, the bond prices and the NAVs can fall. Hence, this is risk involved. Do you want to carry this (interest rate) risk in your portfolio?

If you don’t and want to keep the interest rate risk low, you would prefer to invest in mutual funds that invest in short maturity bonds (overnight funds, liquid funds, ultra-short duration, low duration or money market funds).

Remember, irrespective of whether you invest in short maturity bonds or long maturity bonds (or MFs investing in such bonds), if the rates go down, the fresh investments will be made at lower yields, dragging down future returns.

What is the current Yield-to-maturity for various debt mutual funds?

I pick up the data from ValueResearch for schemes from various MF categories. The data is for the portfolio as on May 31, 2020.

Note that debt MF schemes mentioned below are picked at random and shall not be considered recommendations.

HDFC Liquid Fund: 3.63% p.a.

Parag Parikh Liquid Fund: 3.13% p.a. (this fund invests only in Government treasury bills)

You can see that the YTM for the aforesaid liquid fund is even less than savings bank account interest rate.

HDFC Overnight Fund: 3.18% p.a.  (Fund Category: Overnight Fund)

Aditya Birla Sun Life Savings Fund: 5.59% p.a. (Fund Category: Ultra Short Duration)

Axis Treasury Advantage Fund: 5.10% p.a. (Fund Category: Low Duration)

HDFC Short Term Debt Fund: 7.26% p.a. (Fund Category: Short Term)

IDFC Banking and PSU Debt Fund: 5.76% p.a. (Fund Category: Banking and PSU Debt)

ICICI Credit Risk Fund: 9.29% p.a. (Fund Category: Credit Risk)

SBI Constant Maturity Gilt Fund: 6.13% p.a. (Fund Category: Constant Maturity Gilt Fund)

Note that I have picked up funds at random from various categories. Even within the category, there can a difference in YTMs because of the credit risk or interest rate risk taken.

Remember YTM of a debt MF scheme will keep changing depending on this underlying portfolio.

For the discussed funds, you can see a wide variation in YTM.  However, you must appreciate the source of extra returns. For instance, a credit risk fund invests in riskier bonds, with a higher probability of default. Thus, such bonds have to offer higher interest rates.

YTM (at the time of investment) does not mean you will get these returns. Your net returns will be YTM-Fund expenses. Moreover, there can be defaults in the portfolio.  There will be inflows and outflows, which will require sales and purchases in the fund. In addition to interest rate movements, all this can affect the returns you experience.

You must also consider that bank FDs are risk-free. All debt MF schemes will credit risk or interest rate risk or both to varying extent. Certain debt MFs may give you better returns than bank FDs. The question is, Do you or should you take the risk for the excess return?

What should you do about Lower Bank FD rates?

You can’t do much about it. Make peace with it.  

It is not that interest rates will be low for ever. Interest rates move in cycles. It is possible that the FD interest rates will rise again in a few years.

There are options outside of fixed deposits that offer higher returns at zero risk. You can consider those.

You have RBI Floating Rate Bonds, SCSS and PMVVY. SCSS and PMVVY are only for senior citizens. You can consider tax-free bonds too but their yields keep fluctuating.

If you want to figure out an investment for the long term debt portfolio, PPF, EPF and VPF are good choices.

You will have to consider liquidity issues with these products.

And you can consider debt funds too but you need to select the right debt fund for your portfolio. Do not just focus on past 1-year returns.

What should you not do?

Do not unnecessarily chase returns/yields.

You will see options of investing in corporate NCDs or fixed deposits. Appreciate the risk involved.  You know the struggles of DHFL NCD investors.

Credit risk funds can give better returns. There is a higher risk too. You know what happened with Franklin debt fund investors.

Do not put money in equity funds or gold just because bank fixed deposits are giving lower returns.  With equities and gold, the returns can even be negative. Consider your risk appetite and asset allocation before making such an investment.