Investing in short term debt funds As fixed deposit rates inch closer to 6%, you may wonder if you are better off keeping your savings under the mattress. However, there’s a better alternative available – debt mutual funds. Debt funds are funds that invest in the debt market. What is the debt market? This is the market where fixed-income securities such as corporate bonds, government securities, commercial paper and other such securities are traded. So are debt funds a good alternative to fixed deposits? Yes, and we tell you why.   

Returns

Not all debt funds are substitutes for fixed deposits. Most fixed deposits are made for a tenure of 1 – 5 years. This makes them best comparable to a category of debt funds known as ‘short-term debt funds.’ These debt funds typically hold bonds maturing over a period of 1-3 years.

The table below gives you the returns of a few major short-term debt funds:

Fund Name 1 year return (%) 3 year return (%)
Franklin India Short Term 9.93                9.20
Baroda Pioneer Short Term 8.17                8.88
DHFL Pramerica Short Maturity Fund 8.13                8.89

Source: Valueresearchonline, MoneyControl, Figures as on 3rd November 2017. The list is indicative and not exhaustive.

Note: These funds have withdrawal charges called ‘exit loads’ if you redeem your investment in a short span of time. On 3rd November 2017, these were: 0.5% for withdrawal within 365 days for more than 10% of units for Franklin India Short Term, 0.25% for withdrawal within 15 days for Baroda Pioneer Short Term and no exit load for DHFL Pramerica Short Maturity Fund.

In comparison, major bank FDs offer the following interest rates.

Bank 1 year FD (%) 3 year FD (%)
SBI 6.25 6.00
ICICI Bank 6.75 6.50
Axis Bank 6.75 6.25

Source: Respective bank websites, Figures as on 5th November 2017

Past performance is not a guarantee of future returns. However, though the returns on these funds can change, they have typically outperformed fixed deposits in different periods of time. This is the compensation you receive for assuming a slightly higher level of risk compared to fixed deposits.

Safety

Fixed Deposits are considered to be 100% safe (although this has not been the case in a few instances with co-operative banks). On the other hand, debt funds carry a certain level of risk. This risk is of two kinds. The first is from companies failing to pay back their debt and the second is from interest rate movements. However, debt funds contain these risks by holding a diversified basket of bonds and by optimizing the interest rate profile of their portfolio. Thus the movements in them are much lower than what you will find in say, equity funds.

Taxation

This is the part where debt funds score over fixed deposit in a big way. When you invest in a fixed deposit, you will pay tax on the interest earned as per your tax slab and you are subject to TDS. So, if you are in the 30% tax bracket, this will be 30% – a chunk of your returns is gone.

What about debt funds? When you hold debt funds for more than 3 years, the returns on them are considered as long-term capital gains. Even though you need to pay tax on this, the tax rate will be 20% with indexation. This indexation benefit will help ensure that the tax that you pay is much lower. How? Let’s take an example.

Suppose you had invested Rs. 2 lakh in a debt mutual fund in March 2013 and sold it for Rs 2.8 lakh in April 2016. You had remained invested in the fund for three years. So, the gains qualify for indexation benefit applicable to long-term capital gains of debt funds. Now, in order to calculate the capital gains that you need to pay, we have to calculate the indexed cost of acquisition or purchase. This will help find out what your fund would have been worth if you had purchased it today.

To calculate the indexed cost of purchase, the Cost of Inflation Index (CII) is required. This index is calculated for every financial year as below.

(CII in the year of sale/ CII in the year of purchase) X (fund’s actual purchase price)

In this example, the CII for the year of sale will be 1125 while that of the year of purchase will be 852. So, indexed cost of purchase = (1125/852) X (Rs. 2 lakh) = Rs. 2,64,084

Now, your long-term capital gains after indexation will be Rs 15,916, which is the sale price minus the indexed cost (Rs 2,80,000 – Rs 2,64,084).

The tax on the gains will be Rs. 3,183 (20 % of Rs. 15,916). If you had invested in a fixed deposit and had received the same amount, you will have to pay Rs. 24,000 (30% of Rs. 80,000) as taxes!

Fixed Deposit Debt Mutual Fund
Principal: 2 lakh Investment: 2 lakh
Interest: 80,000 Return: 80,000
Tenure: March 2013 to April 2016 (3 years) Tenure: March 2013 to April 2016 (3 years)
Indexation Benefit – No Indexation Benefit – Yes
Taxable Interest: 80,000 Taxable Gain: 15,916
Rate of Tax: 30% Rate of Tax: 20%
Tax: 24,000 Tax: 3,182

Liquidity

If you decide to close your fixed deposit before it matures, you will not only get lower interest, you might also need to pay premature withdrawal penalty. Debt funds (though not all) also charge a withdrawal penalty, called an exit load. However, in most cases, this penalty applies short holding periods of 6 months to 1 year. Once your holding period crosses the exit load period, you can withdraw from the fund without incurring any penalty. Some types of debt funds such as liquid funds do not have an exit load and can be withdrawn at very short notice.

Convinced that debt funds are better than fixed deposits? Then, why not choose a debt fund today? But do check the expense ratio, entry and exit load of the fund apart from its performance. This will help ensure that you get good returns from your investment.

Author
Staff Writer

This article is written by RupeeIQ editorial staff.