Banking and PSU debt funds: Advantages, taxation and investment suitability

Banking and Public Sector Undertaking (PSU) Funds primarily invest in the debt instruments of the banking sector, public sector undertakings and public financial institutions, aiming to provide a blend of relative stability and reasonable returns.

Let’s discuss these schemes and understand their advantages, disadvantages, and suitability for different investor profiles.

• Table of contents

1. What are Banking and PSU funds?
2. Benefits of Banking and PSU funds
3. Macroeconomic indicators in Banking and PSU funds
4. Income tax on Banking and PSU fund
5. Factors affecting stability in Banking and PSU funds
6. Challenges to stability in Banking and PSU funds
7. Strategies for maintaining stability in Banking and PSU funds
8. Risk management in Banking and PSU funds
9. Banking and PSU funds investment strategies
10. Tips for investing in Banking and PSU funds
11. Who should invest in Banking and PSU funds
12. How to invest in Banking and PSU funds

What are Banking and PSU funds?

Banking and PSU (Public Sector Undertaking) funds belong to a category of mutual funds that primarily invest in debt instruments issued by banks and Public Sector Undertakings (PSUs). These funds focus on fixed-income securities such as bonds, debentures, certificates of deposit, and other money market instruments issued by entities falling under the banking or public sector umbrella.

Banking and PSU funds seek to create a diversified portfolio of debt instruments offered by reputed banks and government-backed entities. They aim to provide investors with a relatively stable investment option by investing in securities with higher credit ratings, thereby reducing the risk associated with default.

Benefits of Banking and PSU Funds

Stability: These funds predominantly invest in instruments issued by banks and PSUs, typically with high credit ratings, providing a level of relative stability to the investment portfolio.

Regular income: Banking and PSU Funds often seek to distribute periodic Income distribution cum capital withdrawal (IDCW), making them a suitable option for investors seeking a steady income stream.

Liquidity: These funds generally maintain a portfolio of liquid assets, offering investors the flexibility to redeem their investments relatively quickly.

Macroeconomic indicators in banking and PSU funds

Some of the major macroeconomic indicators that impact banking and PSU funds include the below.

GDP growth rate: The GDP growth rate is one of the most important indicators of overall economic activity and expansion. A healthy GDP growth rate means rising incomes, more investments and higher consumption levels in the economy. For the banking sector, it translates to better loan offtake as more people and businesses borrow to fuel their spending and investment plans.

Inflation rate: Rising inflation eats into consumer purchasing power and damages business sentiments. High inflation also forces the central bank to tighten monetary policy which pushes up interest rates. For banks, high inflation means higher loan default rates as borrowers' repayment capacities are hurt. It also constricts net interest margins for banks.

Fiscal deficit and government borrowing: A high fiscal deficit means the government is borrowing more from the market to bridge the revenue-expenditure gap. This flooding of debt pushes up bond yields and interest rates over time. It also crowds out private sector borrowers to some extent from the debt market. As major investors in government bonds, a surge in public debt issuances impacts the returns for PSU debt funds.

Current account deficit (CAD): A very high current account deficit poses risks of excess reliance on foreign capital inflows and currency volatility. It also limits the RBI's room for maneuvering on monetary policy due to pressure on forex reserves. A high CAD forces the central bank to defend the currency through higher interest rates. This has adverse consequences for both banks and funds - higher cost of funds, lower lending margins, and reduced returns from fixed income portfolios.

Foreign capital inflows: Strong foreign direct investment (FDI) and stable portfolio capital inflows broaden the sources of financing for India's current account deficits. They also ease pressure on reserves while supporting the rupee. In turn, steady forex inflows tend to steadily appreciate the currency and reduce external vulnerabilities. For banks and funds, surplus liquidity from such inflows typically lowers domestic interest rates and improves the terms of borrowing from overseas financiers.

Interest rates: The policy interest rate or repo rate forms the base for banks' lending and deposit rates. A high interest rate regime compresses net interest margins for lenders, limiting their profit growth. It also reduces borrowers' risk appetite which hampers loan growth. Conversely, gradual rate cuts transmitted through lower deposit/lending rates tend to stimulate credit offtake and economic activity over time.

Taxation of banking and PSU fund

Capital gains tax on banking and PSU fund

Banking and PSU Fund are mandated by SEBI to allocate at least 80% of the total funds towards debt securities. This allocation classifies Banking and PSU funds as debt funds for taxation purposes.

Units purchased after April 1 ,2023 – Gains from Banking and PSU fund investments made after April 1, 2023 are considered to be short-term capital gains irrespective of the holding period. Therefore, they are added to the investor’s taxable income and taxed at the applicable slab rate.

For example, if you fall under the 30% tax bracket and redeem units resulting in a short-term gain of Rs. 50,000, you will have to pay a tax of 30% on the entire amount, which works out to Rs 15,000. Therefore, evaluate your income tax slab before investing in banking and PSU funds for less than 3 years.

Factors affecting stability in Banking and PSU funds

• Credit quality - Funds that invest in high credit quality debt instruments of banks, PSUs, PFIs and municipal bonds have a relatively lower risk of default. This enhances relative stability.
• Government backing - Instruments issued by PSUs and PFIs often have an implicit government guarantee which reduces credit risk. Sovereign instruments also have minimal default risk.
• Portfolio maturity - Funds that maintain a portfolio of short to medium-term securities provide better liquidity and relative stability versus those with longer maturity bonds.
• Interest rate environment – A rising interest rate environment may cause a fall in bond prices and impact performance, thus reducing stability.
• Regulations - SEBI regulations on minimum credit ratings, issuer limits etc. also enhance portfolio stability.

Challenges to stability in Banking and PSU funds

The key challenges to stability in banking and PSU debt funds include the following mentioned below.

• Deterioration in credit quality - Any downgrade in the credit rating of securities held can increase credit risk and reduce stability. Problems in the banking sector can spill over to PSUs.
• Interest rate volatility - Sharp movements in interest rates especially rising rates can lead to devaluation of bond portfolios, impacting stability.
• Liquidity risks - In certain market conditions, lower secondary market liquidity for bonds can make it difficult for funds to meet redemptions.
• Sector concentration - Portfolio concentration in banking and PSU securities increases sector-specific risks relative to diversified funds.
• Macroeconomic risks - A slowdown in growth and business uncertainties can strain the cash flows of issuers. This can increase default risks.

Strategies for maintaining stability in Banking and PSU funds

Banking and PSU fund strategies like limiting the duration and investing in high credit quality instruments are important for relative stability in volatile rate environments. Banking and PSU fund strategies for stability emphasise credit evaluation, liquidity management and active duration management to minimise risks.

• Invest in high credit quality securities of banks and PSUs as mandated by regulations. This reduces credit risk.
• Manage interest rate risk through measures like maintaining a portfolio of securities with varied maturities and limiting duration.
• Ensure adequate portfolio liquidity to meet redemptions by investing in liquid money markets and short-term securities. Maintaining some allocation to liquid government securities also helps.
• Limit exposure to individual issuers and groups to contain concentration risk and sectoral risks.
• Rigorously monitor the portfolio credit quality, watch for rating downgrades, and make timely changes to preserve credit quality.
• Follow a disciplined investment approach within regulatory limits to balance risk-return.

Risk management in Banking And PSU Funds

Credit risk: While these funds predominantly invest in high-rated securities, there is always a certain level of credit risk involved. Monitoring the credit quality of underlying securities is crucial to mitigate default risks.

Interest rate risk: Fluctuations in interest rates can impact the value of fixed-income securities. Fund managers employ strategies to manage interest rate risk, such as modifying the fund's duration or diversifying the portfolio.

Liquidity risk: Though these funds typically maintain a liquid portfolio, unexpected market conditions or high redemptions may pose liquidity challenges. Effective liquidity management is essential to meet redemption demands.

Inflation risk: Inflation poses a risk to the purchasing power of returns yielded by banking and PSU Funds. Despite these funds striving for stability and income, investors must factor in inflation's potential impact on the actual returns of their investments in the long run.

Banking and PSU funds investment strategies

• Relative stability: Banking and PSU funds primarily invest in securities issued by government-backed entities and reputable banks. As per SEBI guidelines for mutual funds, banking and PSU Funds must invest at least 80% of their assets in debt instruments issued by such institutions. This minimizes the risk associated with market volatility.
• Return expectations: Due to their conservative investment approach, Banking and PSU funds aim to provide potentially steady and predictable returns over the long term. This can be particularly beneficial for individuals who seek a stable income stream from their investments to meet their financial needs.
• Liquidity: Banking and PSU funds offer liquidity as they invest in highly rated debt instruments, allowing investors to redeem their units without significant restrictions. This feature provides flexibility, ensuring that funds are accessible when needed.
• Tax implications: Banking and PSU plans are mandated by SEBI to allocate at least 80% of the total funds towards debt securities. This allocation classifies Banking and PSU funds as debt funds for taxation purposes. Gains from Banking and PSU fund investments made after April 1, 2023, no longer receive indexation benefit and are considered to be short-term capital gains. Therefore, they are added to the investor’s taxable income and taxed at the applicable slab rate. However, gains from investments made before April 1, 2023 - and held for a period of 36 months or more - are taxed at 20% with indexation benefit.

Tips for investing in banking and PSU funds

• Diversification is key: While Banking and PSU funds offer relative stability, it's crucial to diversify your portfolio across various asset classes. Consider allocating a portion of your investments to equities and other debt instruments to achieve a well-rounded and balanced approach.
• Align with financial goals: Tailor your investment strategy to align with your specific financial objectives. Whether it's saving for retirement, children’s education, or a major purchase, ensure your portfolio is in sync with your long-term goals.
• Start early: Time is a powerful ally in the world of investments. Begin your investment planning early to leverage the benefits of compounding and ensure a comfortable financial future.
• Regular review and rebalancing: Periodic assessment of your portfolio's performance is essential. Adjust your asset allocation as needed to align with your changing financial goals and risk tolerance.
• Consideration of investment horizon: While Banking and PSU funds are suitable for short to medium-term investments, it's important to align your investment horizon with your financial goals. Evaluate whether these funds complement your overall investment strategy.

Who should invest in Banking and PSU Funds?

Conservative investors – Individuals seeking relative stability and consistent income without taking on high levels of risk often find these funds appealing.

Investors with a medium to long-term horizon – Those aiming for steady returns over a moderate to longer duration can benefit from the relative stability offered by these funds.

Individuals diversifying their portfolio – Investors looking for a balanced portfolio might consider allocating a portion to banking and PSU funds for their relative stability and income generation.

How to invest in banking and PSU funds?

Here's a step-by-step guide to invest in banking and PSU funds?

1. Select a banking and PSU fund. Research banking and PSU funds by comparing historical performance trends*, expense ratios, and the fund manager’s expertise. Assess the types of debt instruments included and the average credit ratings of holdings. These factors help evaluate the fund’s potential suitability based on risk, returns, and portfolio quality.

*Past performance may or may not be sustained in the future.

2. Choose an investment method based on convenience, investing knowledge and cost. You can invest directly through the Asset Management Company that manages the scheme or through a registered mutual fund distributor. You can also invest through aggregator platforms.

3. Make your investment: Access your chosen platform, select the preferred fund, and decide on the investment amount. Choose between a one-time investment or a systematic investment plan (SIP). Complete the payment securely through your bank account to finalize the investment.

Conclusion

In today’s time, it is a wise decision to invest in mutual funds. Banking and PSU Funds offer a balance between relative stability and moderate returns, making them an attractive option for risk-averse investors. However, it's crucial to acknowledge and manage the risks associated with these funds – primarily credit, interest rate, and liquidity risks – to ensure a well-rounded investment strategy.

FAQs:

Are Banking and PSU Funds entirely risk-free?

No investment is entirely risk-free. While Banking and PSU Funds focus on relatively low risk securities, they still carry risks like credit, interest rate, and liquidity risks.

Can these funds guarantee fixed returns?

These funds aim for relatively stable returns but cannot guarantee fixed returns as they are subject to market fluctuations and other associated risks. However, they seek to often distribute regular IDCW, making them an attractive option for investors seeking a steady income stream.

Banking and PSU Funds suit which kind of investor?

Investors looking for relative stability and steady returns may consider a medium to long-term investment horizon, typically over 3-5 years, to benefit from these funds. Furthermore, investors looking for a balanced portfolio might consider allocating a portion to banking and PSU funds for income generation.

What economic indicators reflect the industrial performance in India?

Key indicators that reflect the performance of industries in India include the Index of Industrial Production (IIP), manufacturing PMI and capacity utilisation rate. The IIP and manufacturing PMI provide monthly data on growth across various sectors, while capacity utilisation shows the extent to which installed facilities are being used in production.

How do employment levels impact the banking and PSU fund sectors?

Rising employment rates and faster job creation indicate expanding economic opportunities. This puts more disposable income in the hands of individuals and boosts demand for consumer and retail loans like housing, vehicle, and credit cards. It also means that borrowers will have a higher debt servicing ability which reduces risks for banks.

What is the relationship between fiscal policy and bond market returns?

A high fiscal deficit results in the government borrowing more from the domestic bond market to fund expenditures. This heavy supply of government bonds increases their yields drastically to attract investors. As major holders of government securities, PSU debt mutual funds see the value of their existing bond holdings decline when yields rise sharply. Fiscal prudence with lower deficits is preferable for maintaining stability in bond prices and earning higher returns over the long term.

What is the significance of stability in banking and PSU funds?

Stability in banking and PSU funds provides investors relative steady returns, making these suitable options for conservative investors seeking lower-risk debt investments.

How do economic conditions impact the stability of financial institutions?

Unfavourable economic conditions like high inflation, low growth, and tight liquidity can adversely impact the stability of banks and PSUs by increasing defaults, eroding profits, and creating capital shortfalls.

What is the difference between banking and PSU funds and other debt funds?

Banking and PSU funds primarily invest in debt instruments issued by banks and public sector undertakings, which are considered relatively stable. In contrast, other debt funds may invest in a broader range of debt securities, including corporate bonds with varying credit ratings, making them comparatively riskier.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.