A reader wrote in wanting to invest Rs 10 lakh for six months. He wanted to know whether NPS TIER2 is a better option or a debt fund. And if a debt fund, then which type?
We guide him.
Debt mutual funds.
These comprise of a diverse basket of funds investing into fixed-income instruments. Debt funds are categorized into several categories depending on their positioning across credit quality and maturity at the portfolio level.
They invest in a variety of debt and money market instruments, such as:
- Corporate bonds
- Government securities (G-sec)
- State development loans (SDL)
- Treasury Bills (T-bills)
- Commercial Paper (CP)
- Certificate of Deposit (CD)
The yield-to-maturity (YTM) on these funds depends on the yield of the underlying securities which in turn is a function of the maturity (tenor) and credit quality of these securities. (Do read What is YTM?)
Let’s simplify.
Broadly, they can be looked at based on two parameters. One is the duration of the underlying portfolio. In simple terms, the maturity profile of the securities in a portfolio. The second aspect to be considered is the credit quality; the credit rating of the underlying securities in the fund.
There are liquid funds meant for parking of cash needed for near-term expenses or emergency needs. There is the short-term category, where the funds typically invest in instruments such that the Macaulay duration of the portfolio is between 1-3 years. The shorter the fund’s duration, the more steady in terms of returns, as there would not as much impact due to interest rate movements.
Funds that fall in the Medium to Long Duration category have a Macaulay duration from 4-7 years, while Long Duration Funds have a Macaulay duration from 4-7 years. They tend to do well when interest rates are steady or moving down.
(Macaulay duration is the weighted average time over which a bond’s cash flows are received. Do read What is Maturity and Duration.)
Credit quality could vary depending on the strategy. Corporate bond funds predominantly invest into AA+ and above rated securities, while Banking and PSU funds invest mainly into banks and PSUs which are considered safer from a credit perspective. On the other hand are credit risk funds which have a mandate to invest predominantly into ‘AA’ and below rated instruments.
Funds investing into higher duration securities, subject an investor to interest rate risk since longer tenor fixed-income securities are more sensitive to change in interest rates. While funds that invest in lower-rated securities, subject an investor credit risk.
The gamut of funds in the fixed-income space has varied risk-return profiles to suit different needs of investors. While selecting funds, one should consider the investment horizon and the acceptable level of risk in line with your risk appetite.
SUGGESTION: Given your very short horizon of six months, you can consider investing across liquid, ultra-short term and low-duration and money-market funds which have very low interest rate risk and credit risk. Most funds belonging to these categories have no exit load (except for liquid funds which have a 7-day graded exit load) and any redemptions are credited to your account typically by T+2 business days.
Do consider the Expense Ratio. It is an important criteria to consider when evaluating fixed-income funds. A lower expense ratio results in higher returns assuming similar pre-expense (gross) performance.
National Pension Scheme – Tier II account.
An NPS Tier II account is a voluntary account that can be opened after one has an active Tier I account. The Tier I account is a retirement-oriented product, while the Tier II account is savings oriented.
The Tier II (regular) account does not offer any tax deductions unlike the Tier I account and is not subject to any lock-in. Hence, one can freely invest and redeem when funds are required. Central government employees can avail of tax deduction under section 80C, but investments therein are subjected to a three-year lock-in.
The expenses/charges in case of a Tier II account are the same as in the Tier I account and are lower than that of mutual funds.
SUGGESTION: Given your very short horizon, you should ideally invest into a high credit quality portfolio with very low interest rate risk. Because the fixed-income oriented options under the NPS viz. the Scheme G (investing into G-secs) and Scheme C (investing into corporate debt) options of various pension funds are typically invested into longer duration securities, your portfolio would be subject to high interest rate risk which is not suitable for your short horizon. Hence, the fixed-income mutual fund categories suggested above would be more suitable for your needs as these offer stable returns with low volatility.
Arbitrage funds.
Arbitrage funds are mandated to invest at least 65% of the portfolio into hedged equity positions and the balance into fixed-income instruments. These funds aim to capture the price differential between spot and futures markets, which is largely aligned with money market rates. Hence, the returns for these funds are close to that of money market funds.
From a post-tax perspective, arbitrage funds are favourable since gains for holding periods less than 1 year are taxed at 15% (marginal tax rate for debt funds) excluding cess and surcharge; while in case of holding periods of more than 1 year, only gains in excess of Rs 1 lakh per annum, are taxed at 10% (marginal tax rate for debt funds).
Arbitrage funds typically have an exit load of up to one month.
SUGGESTION: You could invest a small portion of your corpus into an arbitrage fund. If you choose to invest some portion in an arbitrage fund, a word of caution: the fixed-income portion of such funds should be carefully assessed for the underlying credit and interest rate risk.
