It’s a good time to invest in debt funds…

Investors at this point are running scared from the Equity markets into the arms of their evergreen love – Bank Fixed Deposits. Bank FDs are giving between 9-9.5% for one to two year tenure. There are very few banks which are also giving around 10%. If the investor is a senior citizen, they can get another 0.25% - 0.5% extra.

So, is that the best place to invest if you want to invest in debt instruments? It may be if are not paying tax at all or you are in the 105 bracket. But for those in higher income tax brackets, FDs are not the most appropriate instruments to invest in – for the post tax returns would make it less attractive and other competing. Think again, if you thought that there is no competition to the bank FDs, which are offering better returns as compared to NSC, KVP, Senior Citizen Savings Scheme ( SCSS ), PPF etc.

You have debt funds from Mutual funds. For various durations, you have good investment options.

If one wants to invest for short term, one could look at Quarterly Interval Plans ( QIPs ). The instruments which go into these namely CDs and CPs are offering now about 9.1% & 9.4% respectively. Factoring a 0.4% as expenses, the returns come to 8.7% - 9%. It is always desirable to choose the dividend option as the Dividend Distribution Tax (DDT ) is 13.5% now. Taking that into account the post- tax returns would come to 7.53% - 7.79% returns! Not bad for a 90 day investment, where banks offer between 4-7% pretax returns. In fact the returns from even the one year FD for a person at 20% tax slab are between 7.2-7.6% post-tax and for another at 30% tax slab, it is between 6.3- 6.6%. The post-tax returns from QIPs are on par or beating even one year FD returns! So, why not simply invest in QIPs, keep the liquidity intact and keep rolling over, if money is not required. This makes sense especially if you want to invest for the short-term.

FMPs used to make sense too. But with DTC looming on the horizon and impending changes in LTCG, it may be a good idea to roll over the QIPs till March 2012 and then invest in an FMP which matures after April 2013. There are 3 -6 month FMPs too, which one could invest in the dividend mode. Investing in QIPs & 3-6 month FMPs will be beneficial as the Dividend Distribution Tax ( DDT ) is 13.5%. Short term capital gains ( STCG ) on the growth option is at one’s Income tax slab rates and will be suitable only for those in the 10% tax bracket or who do not have to pay tax at all.

For LTCG treatment, the investment has to complete one year from the end of the financial year in which it is invested as per DTC. So if you invest in March 2012 and the investment matures in April 2013, it will be eligible for LTCG. However, though indexation is allowed, the income would be taxed as per the tax slab. This will be positive for those in the lower slabs and will entail higher tax for those in the 30% bracket. QIPs and 3-6 month FMPs maturing in Feb / Mar 2012 can be used for investing in FMPs which mature after April 2013, to claim indexation benefit.
The other debt funds to look out for are Income funds and actively managed funds, for those with a medium to long-term horizon. The interest rate cycle has more or less run the course and income funds will particularly do well. If the investment horizon is 1.5- 2 years or more, this will be a good investment option. Don’t panic if it shows negative returns for a few months though. It will, till the interest rate cycle turns.

The other safe bet at this point would be actively managed debt funds, where the fund manager takes a call on the duration of the papers invested, the type of instruments in the portfolio, timing of the investments etc. Well managed active funds can again reward the investors handsomely. Also, the fund manager would ensure that you don’t slip to negative territory due to the calls he takes. Again the suggested investment horizon would be 1.5-2 years.

Both income and actively managed debt funds have the potential to offer double digit returns. These are indeed better options than bank FDs!

Authored by Suresh Sadagopan ; Published in moneycontrol.com on 12/8/2011