Fixed-income investments are regaining popularity

In the world of investments, there are setbacks. The stock market is fluctuating, bond interest rates are rising, gold isn't sparkling, and cryptocurrency is disappearing.

In fixed-income investments, however, there is a direct correlation between rising interest rates in marked-to-market products and rising accrual levels. To illustrate, the Net Asset Value (NAV) of debt mutual fund schemes is calculated every day at the valuation yield level of the day.

Interest rates and yields have been rising for some time, and because yield and bond prices move in opposite directions, valuation prices are falling.

Over time, your portfolio's accrual level rises as a result of this. What causes this to happen? When a bond matures, it does so at its face value. Because the valuation was done at a lower level, there is a kicker on maturity. The funds are then invested in a higher-yielding (i.e. interest-bearing) account. Furthermore, when the fund receives new money, it is invested at a higher yield than before. Net-net, debt mutual fund returns have been subdued for some time, but the accrual level has been increasing higher, which makes it relatively that.

How can we assess this level of attractiveness, which we claim is higher than before? The closest accessible equivalent is the portfolio yield level, which is the Yield-To-Maturity (YTM) statistics available on the factsheet of every debt fund. You can see the difference between today's yield on debt funds and one year ago's yield on debt funds.

Let's look at an example of how much return you can expect based on portfolio YTM or net of fund-recurring-expenses YTM from now on. Target Maturity Funds are the right category to look at (TMFs). The rationale for this is that in traditional open-ended funds, market movement of yield levels will affect your returns, either positively (to your benefit) or negatively (to your detriment). TMFs are similarly open-ended funds, but the impact of market movement is minimal if you hang on until maturity. TMFs come in a range of maturities, from one year to ten years.

Consider a TMF with a 5-year remaining maturity and a 7.34 percent portfolio yield. This fund's portfolio YTM (yield level) was 6.11 percent a year ago, indicating an increase over the previous year.

TMFs have excellent portfolio credit quality. We calculate the net-of-expenses YTM as 7% in the ordinary plan, minus fund management expenses of 35 basis points (0.35 percent). Long-term capital gains (LTCG) tax indexation is available if you retain your assets for at least three years. The final result is determined by the rate of inflation and the amount of tax relief provided by the government. Your net-of-tax return is 6.7 percent yearly, assuming an inflation benefit of 5.5 percent per year for the following three years.

On a portfolio with good credit quality, this is acceptable. Interim volatility will be there when interest rates rise in the market. You must wait on until maturity or close to maturity for this computation to fructify or for volatility to ease.

Similarly, yields on direct bonds have risen as the bond market braces itself for rate hikes, which the Reserve Bank of India has already begun. We'll use tax-free PSU bonds with a AAA rating as an example, which come in a variety of maturities. Consider a tax-free PSU bond with a 6-year maturity and a yield (i.e. annualised return) of 5.1 percent.

This number is almost 1% greater than a year ago, owing to rising interest rates.

Because this is a tax-free bond, the return is net to you, meaning there are no tax implications. There is a technique for comparing this level to other taxable bonds, where the coupons (i.e. interest revenues) are taxed at your marginal slab rate. If you earn less than Rs 50 lakh per year and are in the highest tax category, your net tax rate is 31.2 percent. For instance, the grossed-up equivalent of other taxable bonds is 5.1 percent / (1-31.2 percent) = 7.41 percent.

To match 5.1 percent net of tax in a taxable bond, you'll need a yield of 7.41 percent. Your net tax rate is 34.32 percent and the grossed-up equivalent is 7.76 percent if you earn between Rs 50 lakh and Rs 1 crore each year. It's important to note that this is not the same as the TMF illustration from before, as the taxation is different.

Conclusion

With interest rates and yields growing, you may be able to earn greater rates in the future. In a defensive product, however, there is a cost to waiting, as you will earn less for that period of time. You can use the concept of a systematic investing plan to stagger your investments.