Since the start of 2012, there’s been a huge debate onto the selection of appropriate investment option among Bank deposits and debt funds or debt Mutual funds. After the announcement of CRR cut by 50 basis points on January 22 this year, it is expected that RBI may move from its stance of controlling inflation to Increasing growth, which means easing of interest rates. If this is going to happen then what should an Investor do? Should they lock in their savings into highly paying fixed deposits at the rate which may not be there after few months or should they take advantage of falling interest rates by investing in debt funds. Through this article I am going to give you a brief idea on what to do after understanding the basics.
What constitutes Bank deposits?
Bank deposits comprises of saving deposits and Fixed deposits which in technical terms called as demand deposits and Term deposits. Most of the banks are offering Fixed deposits rates to the tune of 9.50% p.a for 1/3/5 year term. Senior citizens will be provided 0.5% extra. Effective 25th October’2011 RBI has also deregulated the saving account interest rates which results into many banks start offering 6%-7% on the saving account balances. But here one should understand that these rates are not permanent in nature . As and when RBI starts with its rate cut spree and liquidity starts increasing in the market, all these rates are bound to come down.(Also Read Bank deposit case Study)
What constitutes debt Funds?
Debt funds or Debt mutual funds are those instruments where fund manager invests in the short and long term debt instruments issued by banks, corporates and even government. The papers that the fund manager purchases vary in duration of maturity so these debt funds are sometimes called as duration funds. The investment is generally in the debt papers which carries a fixed coupon rate and pays at regular intervals so debt funds are sometimes called as Income fund also. So depending on where the fund manager has invested and what’s the duration of papers, these debt funds are divided into following categories:
1. Liquid funds / Ultra short Term funds:Objective of these funds is to provide safety of capital at all times. These funds invest predominantly in papers of very short maturities –largely in money market instruments. These funds are comparable to putting money in saving bank deposits.
2. Short Term funds:These funds have maturity longer than liquid (or liquid plus) funds but shorter than income funds. Though its portfolio also is comprised of money market instruments but of higher maturity. These funds suits to those investors who want to park money for 5-6 months.
3. Income funds: These funds invest in corporate bonds, government bonds and money market instruments. The primary aim is to provide regular income with safety of capital. However, these are highly vulnerable to the changes in interest rates.
4. G-Sec or Government Securities fund: These funds can invest only in securities issued by Central and State Governments. As government always borrow for its long term commitments thus it issues papers for 5/10/15 year’s term. Thus automatically this fund becomes long term in nature.
5. Fixed Maturity Plan (FMPs):Almost all the debt funds trade the underlying securities in the market so carries risk of volatility of interest rates and many other factors. But fixed maturity plan is that fund in which underlying papers are held till maturity. So whatever the rate is fixed by issuer, Investor will get that rate after deduction of AMC expenses. These funds are comparable to bank fixed deposits.
6. Floating rate funds: In these cases investment is made in those securities where, the interest offered by the security is linked to some benchmark rate and reset periodically in order to adjust for the changes in the market interest rates. This fund is more or less like liquid funds and its returns move in the same direction where the market interest rates are moving. (Read:How to select debt funds)
Risks prevalent among Bank deposits and debt funds:
I have heard many insurance agents who pitches endowment plan to their clients saying that there investment will be devoid of risk. Even ULIP sellers convince there client by giving this statement and allocate there premium towards more of debt. Even you must be wondering that how come a bank deposits be risky. But one need to understand that risks does not mean the probability of losing capital only, it also includes the opportunity loss, value (purchasing Power) erosion etc. Some of the risks which these fixed income bearing instrument carries are as under:
1. Credit Risk:Credit risk is defined as the risk of not receiving the payment of coupon or principal as per the agreed schedule. Credit risk can arise out of lack of ability or willingness. Lack of ability can be assessed through credit rating of the instrument, whereas lack of willingness is a subjective matter and is difficult to measure.This risk is very less in bank deposits and Zero in Government securities (at least theoretically).
2. Interest rate Risk: This is the risk that the interest rates may go up pushing the bond prices (debt fund NAVs) down. Interest rates and bond prices (debt fund NAVs) share an inverse relationship. Thus in rising interest rate scenario where the debt funds NAV gets affected negatively, there it is an opportunity loss for Bank Fixed deposits and Fixed maturity plan investors. This is in the sense that had they waited for some more time they could have invested on better rates. Longer the duration higher the risk.
3. Reinvestment Risk:Reinvestment risk arises when the coupons are received and the interest rates in the market have reduced. In such a scenario, the coupons get invested at lower interest rates than what the bond earns. The investor could have been better off going for a cumulative option, if it was available. In the falling interest rate scenario this risk is high in Short term funds and short term bank deposits.
4. Liquidity Risk: This risk arises where fund managers invested in the bonds which are illiquid in nature and the investor may not get the money if needed before maturity. Managers of open-end mutual funds have to always keep this risk in mind.(Also Read MF Industry case Study)
Understanding Taxation on Bank deposits and debt funds
Understanding taxation among debt funds and Bank deposits is very important as it becomes one of the parameter of selection among these.
|Tax rates FY 2011-2012|
|Description||Debt Funds||Bank deposits|
|Profit booked within One year of Investment||As per Income Tax slabs||As per Income Tax slabs|
|Profit booked after one year of Investment||10% without Indexation or 20% with Indexation||As per Income Tax slabs|
|Whichever is lower|
|Dividend Received||No Tax||NA|
|Dividend distribution Tax|
|Liquid Schemes||25%+5%(surcharge)+3% (cess)=27.038%||NA|
|Debt schemes other than Liquid||12.5%+5%(Surcharge)+3% (cess) = 13.519%||NA|
* in finance bill 2013-14 , Finance minister has increased the dividend distribution tax in Debt schemes other than liquid and thus are now at par with Liquid schemes which is 27.038%
Let’s take an example to understand it better.
Mohan has 2 options in front of him.Either to invest Rs 1000000/- in 370 days FMP with indicative yield of 9.5% p.a or to select Bank fixed deposits with rate of 9.5% ( compounded quarterly).
|Particulars||FMP (Retail Growth Option) 370 days||FMP (Retail Growth Option) 370 days||Bank Fixed deposit|
|Without Indexation||With Indexation|
|Amount invested (Rs.)||1000000.00||1000000.00||1000000.00|
|Assumed rate of return / interest (%)^||9.50%||9.50%||9.50%|
|Return / interest for first 12 months (Rs.)||95000.00||95000.00||98438.00|
|Return / interest for remaining 5 days (Rs.)||1301.37||1301.37||1348.47|
|Total return / interest for the period (Rs.)||96301.37||96301.37||99786.47|
|Maturity proceeds (Rs.)||1096301.37||1096301.37||1099786.47|
|Indexation Benefit||Not availed||Yes||No|
|Indexed Cost of Investments (assuming 7% rate of Inflation Index)||Not availed||1070000.00||NA|
|Applicable tax rate assuming highest tax bracket + 10% Surcharge + 3% Education Cess||11.33%||22.66%||33.99%|
|Tax liability (Rs.)||10910.95||5959.89||33917.42|
|Receipts net of tax (Rs.)||1085390.42||1090341.48||1065869.05|
|Post-tax return for investment period of 370 days (p.a.)||8.42%||8.91%||6.50%|
The above calculation clearly shows that even if a person comes in lowest tax slab, then also FMP can provide better tax efficient returns after indexation.(if at all inflation is on his side). Moreover when we know that when interest rates are falling, open ended debt funds have potential to deliver better returns
Even when the requirement is to park money less than one year, then also the short term funds and ultra-short term funds prove to be very tax efficient due to less dividend distribution tax.
What to do ?
Before selecting any investment option one should be aware of the risk and potential after tax returns. Since now you are aware of both it would become easy for you to select among debt funds and bank deposits for your short and long term needs. (Do read: How to select debt funds)
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[…] With the linkage of PPF rates with G sec yields, this is very much clear that we may find these rates go down some year. One can recall those years when the G sec rates were in the range of 5.5%-6%. If that scenario has to repeat in the next few years (which is not sure) than Investment in Debt mutual funds would be a wiser choice at present. (Read : bank deposits vs debt mutual funds) […]
If we compare both Bank deposits comes under fixed income plan and debt funds comes under variable income plan (both on the debt side), it merely depends upon the person’s risk ability and current interest rate scenario in the market and the income tax slab under which the individual is falling. Person falling under highest tax bracket of 30% may look to avoid Bank fixed deposits and choose FMP or debt funds
Very true Mayank. Taxation and Inflation are too big holes in an investment which has the potential to deplete one’s savings. and you rightly said that Person falling in high bracket should consider FMPs than Bank FD, to get more tax efficient return.
After the 2013 budget, can i still go ahead and park my emergency fund in liquid plus funds?
What is the better option now?
Budget 2013 has only raised dividend distribution tax structure in debt funds. Liquid plus funds are no doubt better option than parking money in saving bank account. But since emergency doesn’t come after informing so the money should always be parked where it can be accessed immidiately. parking money in saving account or Liquid plus funds totally depend on the tax net you are falling into. But even if we consider taxation aspect still Liquid plus funds carries edge over saving bank account.
If you bank account is such which offers 6-7% interest in saving account than you may consider saving accounts too as upto Rs 10000/- of interest in saving account will not be added in your income.