PPF or debt mutual funds?

Now that the interest rate in PPF has come down and with the debt funds offering double digit returns, should one shift from PPF to debt mutual funds?

Click here to get the answer.

The English translation of the article is as under:

“Should I continue to invest in PPF at reduced interest rates or invest in debt funds to earn between 9% to 12%?” Asked someone recently.

Looking at the question, it seemed he is a keen follower of the financial markets. He was aware of the interest rates on PPF, which have been recently lowered as well as the returns generated by various categories of debt funds.

However, there is a small observation on what he observed. He was referring to what interest rate would be earned in future on the investments in PPF, the debt fund returns were those generated in the past. Aren’t high past returns sustainable? Aren’t professional fund managers supposed to generate high returns? Well, in order to get answers to these questions, it is important to understand the reason why past returns are so high.

As of November 7^th 2016, the returns generated by various categories debt funds are as under:

Fund category	1 year return (%)
Debt: Gilt Medium & Long Term	12.26
Debt: Dynamic Bond	10.85
Debt: Income	10.20
Debt: Credit Opportunities	10.18
Debt: Short Term	9.33

Data as on Nov 07, 2016

Source: www.valueresearchonline.com

As you can see, certain categories of debt funds have delivered handsome returns given that the interest rates last year were below 10% in bank deposits as well as Government Securities. So what caused the debt funds to deliver such returns?

In the last one year, there was one factor that positively impacted the investment returns – drop in interest rates. You may recall that we had covered the impact of interest rate changes on debt securities and hence on debt funds.

Interest rates and bond prices have an inverse relationship, i.e. when the interest rates drop, bond prices rise and vice versa. When the bond prices rise, the NAV of debt funds would also go up.

Now that is one of the components that contribute to debt fund returns. The other component is the interest rates earned on the bonds or debentures that fund has bought.

Let us take an example:

Say a mutual fund invested in the debenture of a company. The debenture was available for purchase for Rs. 1,000 and it carried interest rate of 9% p.a. After a year, similar debentures available in the market were offering interest of 8.5% p.a. The earlier bond looks more attractive due to higher interest rate. It is this increased attractiveness that results in rise in price.

The bond fund would have gained from two things, (1) the 9% interest earned on the bond, and (2) the rise in market price of the bond.

However, the moment the price goes up, the future earnings are now adjusted in line with the new interest rates, i.e. from now onwards, the earnings would be at the rate of 8.5% p.a.

In other terms, the future earnings gap between 9% and 8.5% has been adjusted in the current price of the bond giving a capital gain.

With such an adjustment already completed, the future returns would be a function of (1) current interest rates, and (2) any capital gain or loss on account of change in interest rates in future.

In the above example, the interest rates reduced giving rise to bond prices. If the interest rates in economy move up, the prices of bonds would go down.

For the bond funds to deliver such high returns as the past one year, the interest rates in the economy must drop further. Now that is something I cannot predict.

Keep your expectations low. The past returns may not be sustained in future. After having low expectations, if you get higher returns, enjoy.

At the same time, let us not forget some major benefits offered by debt mutual funds. These are:

·      Diversified portfolio

·      Professional management of the funds

·      Easy and convenient liquidity

·      Flexibility to invest in the same folio

·      Flexibility to redeem full or part of the investments

·      Tax efficiency

It is not just the investment returns, there are many other factors that one must keep in mind before taking an investment decision.

- Amit Trivedi