Investment Blog

Many people rely on historical returns to estimate the expected returns on their debt mutual fund investments. Unfortunately, this is a very misleading way of evaluating debt fund returns.

The historical returns vary significantly from future returns in debt funds due to changes in interest rates. The last year’s return may appear low if the interest rates on average were lower. Now if the interest rates have shot up in the last few months, it won’t reflect in the last year’s return on the debt funds, or rather mark-to-market impact (interest rates are inversely proportional to the fixed-income prices) will further show lower returns on debt funds.

So how do you estimate the expected returns on the debt funds? Here is a simple method:

1. Open a mutual fund data website or take a mutual fund fact sheet.

2. Check the latest yield-to-maturity (YTM) in the portfolio information section

3. Subtract the expense ratio (the expense ratio for direct plans of mutual funds is lower than the regular plans)

4. Your expected returns are net YTM which is YTM – Expense Ratio, over the average portfolio maturity

You will get the expected returns with a few basis points here and there if you hold your investment over the average portfolio maturity provided that the securities in the portfolio won’t default. Therefore, assessing the portfolio holdings is also important to evaluate risk. The higher the risk, the higher the net YTM.

Indexation benefit leading to lower tax (~8-10% on capital gains) when the holding period is more than 3 years in debt mutual funds coupled with this knowledge on the expected returns, you can assess & make a more informed decision on whether to invest in FDs or in a debt mutual fund for your safer investments.

Originally posted on LinkedIn: www.linkedin.com/sumitduseja