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Can debt funds beat inflation?

09 Dec 2021 - Contact Sayan Sircar
11 mins read

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

Can debt funds beat inflation?

Table of Contents


Inflation is one of the axioms of personal finance and enjoys the same amount of 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.

India interest rates


Falling interest rates have led to two effects on portfolio valuation and income. 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.

Impact of inflation

Inflation is an essential input to goal-planning in an economy where prices are rising overall. We can use the rule of 72 as a convenient mental shortcut to understanding the impact of inflation.

Rule of 72

The rule says: Rate of doubling * Time in years = 72

Rule of 72 lets us quickly calculate the impact of inflation over time. Using the rule, we can see that

  • the purchasing power of money halves every ten years at 7% inflation. For example, one crore worth today will be worth 50 lakhs in 10 years and 25 lakhs in 20 years
  • a lumpsum payout, say from an insurance plan, is worth around four times less in today’s money if received in 20 years
  • if you need one lakh/month in living costs in the first year of retirement, that will be two lakhs/month in ten years and four lakhs/month in twenty years
  • if a UG college degree costs 20 lakhs today, it will be 4x that, i.e. 80 lakhs in 14 years at 10% inflation for a 4-year-old today

The above examples show the danger of linear thinking when money is involved. For example, any goal planning that ignores the effect of inflation will lead to inevitable failures when it is time to spend the money. Similarly, investing in insurance plans that give a fixed return over life will lead to getting smaller and smaller amounts in real terms that will be useless in the later years of retirement. The actual calculation is an application of the compounding formula like this:

Cost after N years = Cost today * (1+Inflation) ^ Time

Since you must set goals using the S.M.A.R.T framework, building inflation into the target corpus amount calculation is crucial.

Read more here:

Defining inflation

Before examining returns, we need to check what is meant by inflation data. The government publishes multiple statistics using the MOSPI website that reflects the price increase of a general basket of goods and services. While this is adequate for the country, individual investors should be mindful of the following two points.

Personal inflation

Personal inflation is associated with an investor’s lifestyle. This figure will always be different from government figures. Therefore, to estimate inflation for long term goals like retirement, the investor must keep detailed year-to-year records of household expenses from which inflation can be calculated and will vary from family to family.

Goal-specific inflation

Goal-specific inflation is related to individual goals like houses, cars, college education, and vacations are different, and likely higher than general inflation levels.

Read more here:

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 and not to 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 what are the yearly returns exceeding inflation pre-tax. Success is defined as the number of times the annual returns of the category has beaten inflation over these ten years.

Category Success (pre-tax) Yearly Outperformance (pre-tax)
Dynamic Bond 7/10 3.0%
Banking and PSU 7/10 2.9%
Corporate Bond 7/10 2.7%
Credit Risk 5/10 1.6%
Floating rate 7/10 2.6%
Gilt 7/10 3.4%
Medium to Long Duration 8/10 2.6%
Liquid 7/10 1.7%
Low Duration 7/10 2.0%
Medium Duration 8/10 2.3%
Money Market 7/10 2.1%
Overnight 6/10 1.1%
Ultra Short Duration 7/10 2.1%
Short Duration 7/10 2.6%
Long Duration 8/10 3.7%
10Y Gilt 8/10 3.5%
SBI 10Y FD 7/10 1.5%
Arbitrage 7/10 1.3%

Impact of taxes and post-tax real returns

We adjust taxes over a ten year holding period using CII indexation data from the income tax website. Tax is calculated as 20% tax on profits after indexation for debt mutual funds and 10% without indexation for arbitrage funds, for uniformity 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 8.5% 1.5%
Banking and PSU 8.5% 1.5%
Corporate Bond 8.3% 1.3%
Credit Risk 7.3% 0.4%
Floating rate 8.3% 1.3%
Gilt 8.8% 1.7%
Medium to Long Duration 8.2% 1.2%
Liquid 7.5% 0.5%
Low Duration 7.7% 0.8%
Medium Duration 8.0% 1.0%
Money Market 7.9% 0.9%
Overnight 7.0% 0.1%
Ultra Short Duration 7.9% 0.9%
Short Duration 8.2% 1.2%
Long Duration 9.1% 2.0%
10Y Gilt 8.9% 1.9%
SBI 10Y FD 5.7% -1.1%
Arbitrage 6.8% -0.1%

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

The above table conclusively 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 will cover risk-adjusted returns of debt funds in a future post.

Real returns in the US market

We do not have an extensive history of data for India. For this purpose, it is helpful to look at similar analyses done for US markets. 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 7.5% 0.5%
Money Market 7.9% 0.9%
Overnight 7.0% 0.1%

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 0.1% to 1%. We will stay conservative and assume that long-term real debt returns will be at most zero. As the Indian economy matures, we would 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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