01 December, 2016

Should you stay with FDs or go for debt mutual funds?

Falling interest rate has forced many investors to look beyond fixed deposits in search of better returns.

This is a question that is now on many people’s lips – especially with falling FD rates.  Those who depend on FDs for a regular income, like retired persons, are super worried.  Taxes are eating into their money; inflation is another rodent that is gnawing away at their spending power (even though the inflation monster has been tamed largely now).

Many people are feeling poorer due to these twin assaults.  Hence, the question arises as to whether they should consider other investment options. Many people are wrongly considering entering equity markets, as it appears to have better prospects in terms of returns.  Nothing could be more seriously flawed than that. It is a different asset class with completely different characteristics.

Investments should be made considering the risk-return equation, tenure, liquidity, regular income potential, tax treatment & more.  However, most investors only look at returns in exclusion & leave out the other factors which are equally critical while putting together a portfolio that would take care of their future, in a holistic manner.

The search is hence on for viable alternatives and many people despair that there isn’t any viable alternative. But, there is – debt mutual funds. 
Let us now understand why debt mutual funds are superior to FDs & why one should embrace it.

1)    Better return potential - Debt mutual funds invest in various debt instruments like certificate of deposit ( CD issued by banks ), commercial papers ( CP issued by companies ), debentures, bonds, treasury bills, government bonds (gilts), structured obligations. Most of these are traded and their value is reflected in the net asset value (NAV ) everyday.  Debt schemes are hence composite instruments which offer the returns offered by the underlying instruments as well as capital appreciation (or depreciation ) as the instruments are traded. In a falling interest rate scenario, which is upon us, the value of existing holdings will go up, due to which NAVs appreciate. Due to this many funds are offering 9% + returns today when the average FD is offering 7.5% or less.

2)    Another reason for better returns - There are several opportunities available for mutual fund managers, which are not available to small individual investors.  There are private placements and even one-to-one deals at very favorable rates, which they get access to. The ticket size would be big – even running into hundreds of crores of rupees – which a debt fund manager would be able to commit. The fund manager also has access to a credit appraisal team which also assists in keeping the credit quality of the portfolio in check. One can enjoy all these advantages by simply investing into a debt mutual fund.

3)    Fund manager plays a vital role - The capital appreciation can be different for different instruments. For instance gilts are highly liquid and are mostly long duration papers, which would appreciate the most in a falling interest rate scenario. Corporate papers or T-bills of short duration would appreciate much less in value though. Hence, the capital appreciation potential of a fund is a factor of the portfolio components. Again, it does not mean gilt funds are the best now. In one sense it is – but they can be volatile if the interest rate rises again, for some reason.  Scenarios don’t always unfold with textbook fashion. 

Demonetisation itself is a black swan event, which has ensured that funds which have gilts of especially long duration appreciating significantly (some even as much a 3% in these past two weeks). A small individual investor may find it difficult to understand movements in the debt market, much less take advantage. A skilled fund manager would be able to put together a portfolio to take advantage of market movements and make any changes as may be required in the unfolding scenario.

4)    Advantage tax – In case of FDs, the interest earned is treated as income. Hence, the yield post tax can be significantly lower for a person in the higher income tax brackets. For instance, if the interest earned is 7.5%, the post-tax returns for someone in the 30% bracket would just be 5.18%.  In case of debt mutual funds, one would pay the same tax like a FD if the investment duration is 36 months or less. However, for durations above 36 months, the earnings are subject to long term capital gains treatment. This capital gains adjustment is to factor in inflation. After such adjustment & calculation of long term capital gains (LTCG), one needs to pay 20% on that. Effectively, the tax paid would be 5% or less. On a post-tax basis, even a 7.5% pretax yield would translate to 7.13% returns post tax!!!

5)    Get it when you want it - Debt funds are open ended and are completely liquid; they can be encashed when needed. Also, one can invest in the appropriate category of debt fund based on one’s tenure, liquidity needs, risk bearing ability etc. Many funds have exit loads for a particular period, after which it is nil. Some funds do not have any exit loads at all. 

FDs have a tenure and if one exits prior to that, lower interest rates would apply, depending on when the cash out happens. Hence, debt mutual fund scores especially if the timing of an event for which money has been invested, is unpredictable.

6)    Setting up an income is a breeze –  FDs offer predictable income streams, which is one of the reasons which endears it to the investing public.  However, the income normally can come in quarterly, half yearly or annual manner only. Also, the amount coming in is fixed, based on the interest being offered. It cannot be tailored as per one’s needs. For instance, if one wants just half the interest income & wants the other half to remain invested, it is not possible. Nor, can one stop receiving an income.

In a debt fund, one can setup a systematic withdrawal of an amount of one’s choice ( which ideally should be at or below the earnings of the fund), stop it if needed, increase it if necessary, set the frequency as convenient… in short, it is very, very flexible. If income is not needed, one can simply allow the corpus to accumulate and set up a systematic withdrawal when needed.

Again in systematic withdrawal, the tax incidence is less as the withdrawn amount is treated as redemption as against income. Hence, one pays capital gains tax (short or long term ) on the difference between current price less acquisition price.

There are several things in favour of a debt mutual fund. Debt mutual fund is a big category. Within that too, one needs to choose the right fund based on one’s needs. A good advisor can assist here to select an appropriate fund that will work well for an investor, based on their requirements for funds in future. 

Debt funds have always been a good choice. Today, one may have very little options apart from this.

Article first appeared on Money control :
Should you stay with FDs or go for debt mutual funds?

Author  -   Suresh Sadagopan  | Founder | www.ladder7.co.in

#SureshSadgopan #FinancialPlanner #FinancialAdvisor #Fiduciary #LifePlanning #FeeOnly #HolisticAdvice #Ladder7

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