“If you never try, you will never know.” – Unknown
Key takeaways:
- With falling fixed deposit interest rate, it is time to look at other options that can deliver better post-tax return.
- Debt mutual funds can be a good alternative to fixed deposit. It is more tax efficient and offers a lot of flexibility.
- For more than 3 year holding period, one can look at dynamic bond fund, for less than 1 year, look at liquid fund. Choose carefully between corporate bond funds and gilt funds to suit your requirement.
Few days ago, SBI announced another round of cuts to the fixed deposit rate. After the latest round of rate cuts, fixed deposit rates up to 1 year has fallen further below 6%. If you are in a higher tax bracket, the post-tax return will be sub 5%. Even for senior citizens, the pre-tax interest rates are below 7% for maturity up to 10 years.
Despite some turbulence, below is what various categories of debt mutual fund schemes have delivered. As interest rates fell, debt funds that invest in longer maturity debt instruments have delivered 10% to 15% type of return. Credit risk funds that invest in corporate bonds have not delivered good returns over the last 1 year.
If you look at 3 to 5 year returns, you see more stability across different types of debt mutual fund.
As I often say that there are no free lunches in the world. If you go for higher return, you will have to absorb higher volatility. However, higher volatility doesn’t necessarily mean higher probability of loss. For example, If we have to go from Delhi to Bangalore, we can either go by train or by aeroplane. Now, journey by aeroplane is short but some people also feel its bit more risky. However, one were to look at the data, accident and fatality rates for flights is far lower than trains in India.
So, sometimes we have a perception of risk which might not be consistent with actual risk. Normally, the general perception about mutual funds is that they are risky. However, the available evidence suggests that people have lost more money by ignoring mutual funds and investing in other products (gold schemes, chit funds, high return ponzi schemes). Debt mutual funds, if chosen properly, can prove to be a good vehicle for better post-tax return.
Balancing risk and return in fixed income investments
Bank fixed deposit has two main advantages over market-linked fixed income investments:
- Safety of principal amount: If you invest in the fixed deposit schemes offered by major public sector or private sector banks, you can be reasonably sure about the safety of the principal amount.
- Certainty of return: The return you are expected to get is known at the time of investment. It may be low rate of return but there is now uncertainty about what it will be eventually.
As the bank fixed deposit rates are coming down drastically, the key question is how to increase return potential without compromising on safety of principal and certainty of returns? I feel debt mutual funds could provide a more tax-efficient solution here.
Debt mutual funds need a closer look at current juncture
Unlike fixed deposits, there are lots of variations in debt mutual funds to cater to your needs. So, you can classify debt mutual funds along two dimensions:
- Type of instruments they invest in: government securities or corporate bonds
- Maturity of instruments they invest in: Like 6-months FS, 12-month FD or 5 year FD, debt mutual fund schemes can invest in instruments of various maturities.
Simple rules for investing in debt mutual funds
You can simply google to check 10Y Indian government bond yield. Currently, 10Y government bond yield is hovering around 6.5%. Now, higher the 10Y bond yield, higher will be prospect of future returns because yields in India, structurally, fall over the medium-term. Some simple rules for investing in debt funds:
- If you don’t want to worry about yields or how they are going to move, dynamic bond fund is a good option.
- If you don’t want to worry about credit risk, choose debt mutual funds which invest predominantly in government securities (gilt funds).
- If you need money in less than 1 year, better to go for liquid or ultra-short term fund.
- For 3 year or longer holding period, dynamic bond fund or low to medium duration gilt funds can be chosen.
Lot of negative newsflow has been around credit risk funds. These funds essentially invest in corporate bonds of various ratings. In the last 1 year, we have had some instances of default by companies. As a result, credit risk funds have delivered poor returns compared to other categories of debt mutual fund schemes.
Prominent fund managers like S Naren of ICICI mutual fund feel credit risk funds should perform well as they are better value (Asset allocation a sure shot way of making money – S Naren). However, if you don’t know how to pick a credit fund, please contact your advisor who can guide you.
Key advantage of debt funds – flexibility and tax efficiency
Compared to conventional fixed deposits, debut mutual funds offer far more flexibility and are more tax efficient. Unlike FD, you can get the money anytime you want without any penalty. Once you sell your debt mutual fund holding, you get the money in your bank account the very next working day. Furthermore, some debt mutual fund scheme offer instant redemption up to 50000 or 90% of debt mutual fund value (whichever is less). You redeem and you get money immediately.
One big advantage of debt mutual funds for people in high tax bracket is their tax efficiency. You can find more on this here –Taxation of debt mutual funds
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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