Interest income from Fixed Deposits is taxable at marginal rate of taxation of the assessee. Add it to your total income and get taxed at slab rates applicable to your total income. This is where debt mutual funds score over Fixed Deposits, debt mutual funds for holding period greater than three years are taxed at 20% after adjusting the cost of inflation index in purchase price. It gives a decent tax arbitrage to assesses having taxable income in 30% tax bracket.
In debt mutual funds there are three types of risk:
- Interest Rate Risk
- Credit Risk
- Liquidity Risk
Interest Rate Risk:
As we all know, there is an inverse correlation between price of the bond and rate of interest. This risk can be avoided by investing in schemes following roll down maturities or target maturity ETFs.
In case the issuer defaults on coupon or principal or both, investors can potentially lose their entire capital.
In an open-ended debt fund, AMC is bound to honour redemptions within 10 working days and standard business practices are to honour redemption at T+1 days, provided the investor has submitted a valid redemption request before cut-of time. In case the redemption requests (in rupee terms) received by the fund house for a particular scheme is greater than the liquid marketable assets in the fund, the scheme has the option to borrow up to 20% of the net AUM. What if the redemption request is even more than that? This is exactly what happened in six of the Franklin Schemes. It is known as liquidity risk.
Through a notice dated April 23, 2020, the Trustees of Franklin Templeton Mutual Fund in India announced their decision to wind up six schemes
- Franklin India Low Duration Fund
- Franklin India Ultra Short Bond Fund
- Franklin India Short Term Income Plan
- Franklin India Credit Risk Fund
- Franklin India Dynamic Accrual Fund
- Franklin India Income Opportunities Fund
AMC blamed it on COVID-19, extended lockdown and very low liquidity in lower rated bonds. These 6 wound up schemes are no longer available for subscription or redemption post cut-off time from April 23, 2020. All Systematic Investment Plans (SIP), Systematic Transfer Plans (STP) and Systematic Withdrawal Plans (SWP) into and from the above-mentioned funds have been cancelled by the AMC post cut-off time from April 23, 2020.
SEBI in October 2017 classified the debt schemes under 16 categories, only 2 of the categories were based on credit profile of the scheme rest were based on maturity of the schemes. Two categories which were based on credit profile are:
1) Corporate Bond Funds: 80% of the net assets have to be invested in only in highest rated papers.
2) Credit Risk Funds: 65% of the net assets have to be invested in instruments below highest rating.
Let us now see the split of assets as on 31st march’2020 in 16 categories of debt mutual funds.
Investors have seen maximum pain in this category. Look at the returns on different time frames.
In the credit risk category, 41335 Crore of funds have been flown out from these categories since 31st March 2019.
There have been instances of markdown in other categories as well. Look at the impact of DHFL default on open ended funds and Fixed Maturity Plans, below two pics represents only one day of markdown.
What shall investors do?
Investors should take help from their financial planner (please note your mutual fund distributor, LIC Agent or Bank relationship manager is not your financial planner) & DIY investors should stick to simpler solutions like target maturity funds and open ended mutual funds running roll down maturity with near to highest credit quality.
This article has been written by an aspiring fee only financial planer who intends to start affordable fee only advisory after getting the licence from SEBI. Writer can be reached on twitter @stepbystep888 (Nishant Batra)