Fixed Income: Bonds vs Bond Funds

Bond funds, or income funds, have not been attractive as an investment in the past five years, except in 2008. Like equity funds, there are years when returns from bond funds could be negative too (See Table). If we invest directly in fixed-income instruments and do not trade in them, we do not face this volatility. We enjoy the return which we had calculated while investing. The risks faced by us are of liquidity (not being able to sell when we want to) and one of default (if we are unlucky to be holding a lemon). If we can manage default risk well, liquidity is available on most listed bonds, albeit at varying market prices.

But there is one big difference.  Fixed-income products attract higher income tax. So, even if bond funds gave lower returns, they may be winners if we factor in the tax impact—and not because the fund management has delivered higher returns. When we invest directly, we simply hold the investment till maturity.

Unfortunately, a fund manager cannot do that in an open-ended fund. He has to invest new inflows, sell to meet redemptions and, at the same time, keep an eye on interest rate changes that take market values up or down on a daily basis. Most bond funds have problems in giving a threshold return comparable to that of a fixed deposit, over most periods.

Direct investment in bonds is a good option. There is no deduction of tax at source if one invests in a ‘listed’ bond or debenture. For senior citizens, this could be attractive considering that they enjoy a higher tax exemption limit.

Liquidity is not a major issue and my experience is that, for reasonable amounts (say up to Rs50 lakh), one can find buyers in the secondary markets within three to four working days. Also, as I mentioned in an earlier article, if we do not expect interest rates to rise from here, bonds are good. When the interest rates start to fall, it would normally be possible to sell the bonds in the secondary market at a price higher than what one paid for them.

This could be a good time to enter the fixed-income family—whether it is bond/income funds or gilt funds. It is very unlikely that interest rates will go up from here. And one must get in before interest rates actually decline. It could mean one year or so of waiting but, in case interest rates drop across the board by a couple of percentage points, income funds could deliver more than 15% returns. And this return would be tax efficient compared to direct investment in fixed-income instruments. So far, it has not happened this year due to the very tight liquidity conditions. If we see demand tapering or inflation cooling off, interest rates could fall. If this were to happen in 2012, then it makes great sense to invest now in income funds. In 2008, as interest rates fell, the returns spiked to over 20% for that year!

Of course, no strategy is foolproof. There are two risks to this visualised outcome. One is that interest rates may not change at all, given the tight liquidity and the increasing credit demand. (If interest rates do not come down, it is going to be very difficult to achieve project viability in many infrastructure projects.) Income funds, in that case, would deliver around 7%-9% over one year, which is better than the returns on savings account. The other risk is that interest rates could go up from here, resulting in capital loss. I would rate the risk of this happening as the least of the three (rates remaining static, falling or rising). Hence, in terms of risk-reward, I would not hesitate to move some money into income funds.



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Changes in Our Business Model
25th Sept 2020
Greetings from Moneylife Advisory Services
Between financial years 2019-21, SEBI has come up with extensive changes to investor advisor regulations. On Sep 23, 2020, SEBI had issued new additional guidelines. This comes just two months after extensive changes announced in July 2020. Earlier, in December 2019 there was an ad hoc circular
As a result of these changes, IAs, cannot accept fees through credit cards, will have to sign a 26-clause investor agreement, have to maintain physical record written & signed by client, telephone recording, emails, SMS messages and any other legally verifiable record for five years. IAs were already asked to record the suitability and rationale for every piece of advice given, sign them and store them for five years.
While these extensive and frequent changes, designed to strengthen the conduct of IAs are well-meaning, these have sharply increased compliance efforts and cost. We, being online advisors, find many of changes harder to implement, compared to advisors working in the physical space. We will have to have an army of advisors, administrative and tech staff to be compliant. If we do this, we will have to divert money to these areas and the cost of our service will double. We want to remain the least-cost service in the market to benefit more and more people. In the circumstances, we are forced to change our business model from “advisory” to “research”. This will mean the following:
What remains the same:
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  • We will have to suspend the restructuring tool.
What changes:
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Over the next few weeks our site and our communication to you will reflect these and other additional changes.
We feel this will not affect you much in terms of what really matters in investing: knowing what to buy and when to buy. This is our edge and it will still be available to you.
Debashis Basu