Major banks in India like State Bank of India, HDFC Bank and ICICI Bank have raised their term deposit rates recently. The Fixed Deposit (FD) rates range from 6.5% to 7.5% for deposits less than Rs 1 crore depending on which bank you go to. While FDs are looking good this year, one-year returns of fixed income mutual fund schemes have declined as bond yields went up (bond prices go down as yields go up). Liquid funds returns this year were 6.8% as on 30th Nov-18, which are less than the current available FD rates.
Medium duration category funds, with Macaulay duration – which is a measure of a‘s sensitivity to interest rate changes – between one to four years, seems to be the right comparison against three-year FD. They have delivered 4.63% for one year and 7.29% for three-year period as on 30th Nov 18. So, on the face of it, bank FDs were looking attractive with rates being hiked frequently by banks. But the question is should you withdraw money from your debt funds and rush to a bank to open an FD?
A retail investor is often tempted to look at higher returns on paper without giving much thoughts to long term goals, capital appreciation and tax efficiency. True, if an investor wants to keep the money for extreme short-term situations like one to three months, then FD is not a bad idea. It protects your capital, and you can break the FD whenever you need the money. But if you want fixed income on a medium to long term basis (anything more than three months), then you may be better off keeping that money in debt funds only.
There are a few reasons why. For instance, historically debt schemes have provided an alpha of 1-2% compared to bank FDs. Besides, even if we consider that both FDs and debt mutual fund schemes are delivering similar returns, one can get higher post-tax return from debt schemes thanks to the indexation benefits, and the treatment of income as capital gains.
Indexation benefits and tax efficiency
Let’s take a look at how indexation works and how much difference would it make to your gain for a three year period. In our example below, both the FD and the debt scheme are assumed to give 8% rate of returns per annum. For this calculation we are considering actual inflation figures. Tax is calculated for highest tax slab.
|Parameters||Fixed Deposit||Debt Scheme (With Indexation)|
|Investment Amount (A)||10,00,000||10,00,000|
|Past 5 yr Returns||8% p.a.||8% p.a.|
|Value after 5 yrs (B)||14,69,328||14,69,328|
|Indexed Cost (C) = Inv Amt * (CII maturing year / CII purchase year)||–||13,60,000|
|Taxable Gain||(B) – (A)||(B) – (C)|
|Post Tax Gains||13,23,883||14,47,462|
|Post Tax Returns||5.77%||7.68%|
|Inflation Adjusted Post Tax Returns||Fixed Deposit||Debt Scheme (With Indexation)|
We further extended this analysis to five year period and plotted a growth of Rs 10 lakh invested five years ago.
Here is how the chart looks for the growth in inflation adjusted returns.
The additional gains owing to tax benefits are clearly visible. That too after considering similar returns for both FD and debt scheme.
Also remember, the debt fund returns are capital gains (long term capital gains in the case of investments above 36 months and short term if held less) as per tax rules while FD returns are interest income irrespective of how long you hold it. You can set off capital gains against any capital losses you have incurred in the previous seven financial years. While interest income will be added to your income of the particular financial year and will be taxed as per your tax bracket. Besides, as illustrated in the table, indexation benefits are available to investments which are older than 36 months.
There are other benefits too where debt mutual fund schemes score over FDs. We do a comparison of these parameters:
Transparency: Both debt funds and bank FDs invest in corporate bond market. Banks make use of the money locked in saving deposits to lend to corporates; debt funds also invest money pooled from investors to lend to corporates. However, in case of FDs, investor can never know which business is being funded by his savings while debt funds publish the portfolios every month. That said, bank FD gives you assured interest on your deposit with capital protection (banks are regulated by RBI and the government makes sure the banks are solvent), while debt fund returns could fluctuate depending on the underlying bond prices. External interest rate environment could affect positively or negatively the debt fund returns.
Governance: The recent crisis in NBFC sector has thrown light on the asset-liability mismatch (ALM) issues in banking and NBFC sector. When the money locked in for short tenure of 1-3 years is lent for more than three years there is a mismatch which can potentially escalate and result in defaulting on payments to investors. Asset-liability mismatch is a normal practice in banking segment, to fill the ALM gap, banks issue Commercial Papers. In case of debt fund, money is lent for the period indicated by its average maturity. Thus, investor can choose to invest in a scheme that matches his/her requirement.
Cost: Corporate lending is done at higher rate than the borrowing rate therefore the difference between FD interest rate and corporate lending rate is bank’s profit. There is no way for an investor to know this spread. In case of debt MF scheme, money management charges are reflected in expense ratio which can be compared with peers. And the entire interest earned on corporate lending is transferred to investors.
We strongly recommend investors to assess their goals before investing their money. From comparison perspective we think debt mutual fund schemes are a superior alternative to bank FDs. Even as the FD rates look better optically, in the long run they are unlikely to outperform debt schemes. Our thesis is based on historic data analysis.
Currently, it is prudent for investors to hold on to their existing debt exposures. For incremental allocation, investors may choose from high quality, short term schemes like Ultra Short Term, Low Duration and Corporate Bond Schemes having lower modified duration (which is a formula that expresses measurable change in the value of a security in response to a change in interest rates.). Bonds with higher durations have greater price volatility than bonds with lower durations.
While it’s understandable that investors seek safety and they worry when their investments don’t perform as per expectations. But it is also important to note that markets go through cycles. There will always be one such instance in medium term when underperformance is experienced. For long term wealth creation, it is imperative that investors stay put during bad times as well.