Replace Fixed Deposits With Mutual Fund Schemes
The worst hit by the lower interest rates are investors who had relied on bank fixed deposits to earn interest. The option for such investors is to shift to debt mutual funds.The article explains why
Having made our exit from one of the most traumatic years in recent history, optimism has certainly taken wing after the US election and affirmative news about the vaccine. Even the best of experts could not have predicted what unfolded in the year 2020. The corona virus-induced lockdown and subsequent action by central banks and government led to a dramatic fall in the interest rate. Between February and May 2020, the apex bank of India cut the key policy rates by 1.4 per cent. The latest comment from the Reserve Bank of India (RBI) head indicates that lower interest rate is likely to stay here for a while.
The worst hit by such a lower interest rate are investors who had relied on bank fixed deposits to earn interest. Since the start of the year there has been drastic fall in the fixed deposit rates offered by banks for all kinds of tenure. We see that the interest rate offered by India’s largest bank, State Bank of India (SBI), has been cut by more than 1.5 per cent for various tenures since the start of the year. For example, the interest rate offered for the duration of 7-45 days has fallen from 4.5 per cent to 2.9 per cent – a decline of 160 basis points. The interest rate for long duration has fallen less than the short term.
In the same period, the returns offered by mutual fund products have been quite exceptional. Even the returns offered by debt funds have been better than the rates offered by bank fixed deposits with an exception of the credit risk fund. There are 16 sub-categories of debt mutual funds based on the types of instruments they invest and the maturities of such instruments. For example, overnight funds are those that invest in overnight securities having maturity of a single day; similarly, liquid funds invest in debt and money market securities with maturity of up to 91 days.
The interest rate offered by banks for different durations varies from 2.7 per cent in savings bank account to 5.4 per cent for fixed deposits between 5-10 years’ tenure.
Taxation Factor
The returns shown above do not take into account the taxation part and are pre-tax returns. In case of debt mutual funds, if the gains are arising after three years of investment then they are considered long-term capital gains (LTCGs) and taxed at the rate of 20 per cent with indexation benefit. Indexation is nothing but a method in which inflation is factored in at the time of purchase to the sale of units. However, for gains arising before three years, short-term capital gain (STCG) tax is applicable. Here, all your STCG gets added to your overall income and is taxed as per your individual tax slab rates. In case of interest earned from your savings bank account, it is taxed at a rate of your tax slab after deducting Rs10,000. In case of interest earned from your fixed deposit, it is added to your income and is taxable according to your tax slab.
Post-Tax Returns
For an investor, it is the post-tax return that matters. We assume that an investor will invest for more than three years in both bank FDs and debt mutual fund. In such a case, LTCG tax is applicable for mutual fund investors with benefit of indexation. The table below shows the post-tax yield of investments with different tax rates. We see that the post-tax yield for someone investing in debt mutual fund is far better than someone who has invested in bank FDs. The return difference increases as the tax slab increases for an investor. The reason being any investment in debt MF is taxable at a lower rate with indexation benefit if it is held for more than three years.
Even if we consider investment for less than three years, investments in debt MFs are a better option. The average return generated by debt MF in the last one year is 7.75 per cent compared to FD rate for the same duration offered at 5.1 per cent.
Choosing the Right Fund
Hence, it is clear that you can replace your bank FDs with a debt MF. Since there are 16 categories of debt MFs you can chose one that matches your investment horizon and risk profile. Nonetheless, to get the most out of your fixed income investment we need to understand the current macro-economic environment and the interest rate scenario going ahead.
The central bank in India is very much keen to ensure that the current growth rate becomes broad-based. This was reflected in RBI’s dovish measure and continuation of accommodative stance and further rules out the possibility of a rate hike in the near term, which was the biggest fear expressed by investors at the onset of continued higher inflation.
Therefore, there are chances of rate compression at the longer end of the curve. Besides, the difference between shorter (three months) and longer (10 years) bond yield is 300 bps which was 130 bps during the pre-pandemic times. Besides, attractive investment opportunities are emerging in selected non-AAA-rated bonds; however, their spread with AAA-rated bonds continues to remain at elevated levels against the historical average, suggesting that risk aversion is still in place. Going forward, improvement in growth outlook and ample liquidity may lead to broad-based moderation in credit spreads.
This favours some non-AAA exposure based on individual risk appetite. Hence, investors who want to play duration and have appetite for volatility can look to invest in the gilt and dynamic bond funds’ space. While investors looking for relatively higher yield to maturity can consider a floating rate fund, medium duration fund and credit risk fund segment. We believe that as the accommodative stance of apex bank will continue, this will augur well for bonds. Your investment in debt MFs should be guided by the above discussion on attractiveness of different categories of debt MFs and your asset allocation plan.