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Can debt funds beat inflation?

Many investors have a need where they want the safety of assured returns and wish to beat inflation simultaneously. Can debt funds do that?

Can debt funds beat inflation?


Posted on 09 Dec 2021
Author: Sayan Sircar
10 mins read
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Many investors have a need where they want the safety of assured returns and wish to beat inflation simultaneously. Can debt funds do that?

Can debt funds beat inflation?

📚 Topics covered:

Introduction

Inflation is one of the axioms of personal finance and enjoys the same permanence as death and taxes. Investors who are looking for safety in debt as an asset class would have a perpetual worry as to whether debt products beat inflation or not. Given the downtrend in interest rates in the last decade, anyone dependent on debt as an asset class, pensioners, and general investors allocating a part of their portfolio to debt products have a cause for concern.

Chart: Arthgyaan • Source: RBI • Get the data

Falling interest rates have led to two effects on portfolio valuation and income. First, long-duration bonds have risen in price over this period while interest income from fixed deposits, small saving schemes (like provident fund, NSC) and annuities have gradually come down.

India inflation

Source: Ministry of Statistics and Programme Implementation (MOSPI)

We will examine the historical returns of debt mutual funds and SBI 10-year FD rates vs inflation.

Related:
Inflation: the impact on your goals and how to choose assets that beat it

Debt returns vs inflation

Using inflation data from MOSPI, SBI 10-year FD rates and mutual fund data from Valueresearchonline, we have created the following exhibit showing yearly inflation and category-wise returns (not that of an individual fund) of debt funds (regular plans until 2014, direct plan post that) and SBI 10-year FD. The inflation figures are from MOSPI and apply to the whole country, not an individual investor. The returns are also pre-tax.

We have also added Arbitrage funds to this list. Many investors prefer these funds because of their debt-like returns and equity-like taxation.

(click to open in a new tab)
Debt returns vs inflation in India

The diagram shows that no single category, including FD, has consistently beaten inflation over this period.

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Choosing a debt fund category to beat inflation

We collate the information in the image above to show how the categories have behaved year-wise vs inflation and the yearly returns exceeding inflation pre-tax. Success is defined as the number of times the annual returns of the category have beaten inflation over these ten years.

Category Success (pre-tax) Yearly Outperformance (pre-tax)
Dynamic Bond 70% 2.8%
Banking and PSU 70% 2.6%
Corporate Bond 70% 2.6%
Credit Risk 60% 1.9%
Floating rate 70% 2.4%
Gilt 70% 3.2%
Medium to Long Dur 80% 2.5%
Liquid 70% 1.3%
Low Duration 70% 1.8%
Medium Duration 80% 2.4%
Money Market 70% 1.9%
Overnight 60% 0.8%
Ultra Short Duration 70% 1.9%
Short Duration 70% 2.4%
Long Duration 80% 3.4%
10Y Gilt 80% 3.4%
SBI 10Y FD 70% 1.4%
Arbitrage 70% 1.2%

Impact of taxes and post-tax real returns

We adjust for taxes over a ten-year holding period using CII indexation data. Tax is calculated as 20% tax on profits after indexation for debt mutual funds and 10% without indexation for arbitrage funds, for uniformity’s sake.

More details on taxation of mutual funds are here: How is tax calculated on selling shares/MFs?

We have assumed a 30% tax on FD. For simplicity, we assume that the FD tax is paid on maturity. If the tax on FD is paid yearly, the effective return will reduce further.

Return over inflation, i.e. real return, is calculated as

Real return = (1+Nominal)/(1+Inflation)-1

Category Nominal post tax return Return over inflation post tax
Dynamic Bond 7.9% 0.9%
Banking and PSU 7.8% 0.8%
Corporate Bond 7.8% 0.8%
Credit Risk 7.1% 0.2%
Floating rate 7.6% 0.7%
Gilt 8.3% 1.3%
Medium to Long Dur 7.6% 0.7%
Liquid 6.7% -0.2%
Low Duration 7.1% 0.2%
Medium Duration 7.6% 0.7%
Money Market 7.2% 0.2%
Overnight 6.3% -0.6%
Ultra Short Duration 7.2% 0.2%
Short Duration 7.6% 0.6%
Long Duration 8.3% 1.3%
10Y Gilt 8.5% 1.5%
SBI 10Y FD 5.3% -1.6%
Arbitrage 6.4% -0.5%

Since FDs are taxed at individual slab rates, investors at high slab rates should avoid them for long-term goals unless they need the principal protection of FDs.

The above table proves that the investor has to take risks to beat inflation using debt funds. Some observations:

  • funds with the least credit risk and interest rate risk have given a real return of slightly above 0%
  • surprisingly, increasing credit risk via credit risk funds has not produced a better return on aggregate
  • there is inconsistency in the way increasing duration has impacted returns. For example, the Medium Duration category has produced worse returns than Short Duration because SEBI does not define the credit profile of these funds, and fund managers have the opportunity of choosing various kinds of bonds
  • to beat inflation post-tax, the investor has to go beyond short-duration funds and get exposure to both interest rate and credit risk
  • gilt funds have beaten inflation; however, they have considerably high risk due to the long-duration nature of these bonds
  • arbitrage funds, even with favourable taxation, have not beaten inflation

We have covered tax-adjusted returns of debt funds here: Pay lower capital gains taxes for debt mutual funds: understand how indexation works

Real returns in the US market

We do not have an extensive history of data for India. For this purpose, looking at similar analyses done for US markets is helpful. How to Invest Your Money When Inflation is High has an excellent discussion on real returns of multiple asset classes in the US.

Effect of inflation on the retirement model

SEBI Debt fund matrix Jun 2021

Our debt fund selection process focuses on choosing debt funds

  • Maximum Credit Risk of Scheme equal to Class A (CRV >= 12) - relatively low credit risk
  • Maximum Interest Rate of the scheme equal to Class I: (Macaulay Duration <= one year) - relatively low-interest rate risk

Read more: How to choose a debt mutual fund?

Category Post tax return Return over inflation
Liquid 6.7% -0.2%
Money Market 7.2% 0.2%
Overnight 6.3% -0.6%

As per the table of post-tax real returns, we see that as per the above framework, real returns for the portfolio can range from -0.6% to 0.2%. Therefore, we will stay conservative and assume that long-term real debt returns will be at most zero. As the Indian economy matures, we expect real returns for high credit quality, low-duration bonds to fall further, as shown in the data from the US.

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