Debt Mutual Funds Or Public Provident Fund: Take Your Pick!

Both debt funds and the public provident fund have their advantages and drawbacks when it comes to returns, withdrawal facility and taxation. The article takes a deeper look at how these work out for an individual investor and provides guidelines that may match your requirements



Broadly speaking, there are two ways of investing – the conservative way and the aggressive way. In between there is also a moderate way and its different shades. Every investor is unique in terms of his or her distinct financial objectives, risk-taking capacity, expected returns from investment, etc. Typically, individuals are driven by emotions and every individual’s investment decisions are influenced by various emotions and the situations they face. But naturally then they are very attentive and concerned about investing their hard-earned money in any of the investment instruments.

As such, any untoward event such as default by a company on its debt re-payment in case of fixed income investment or a deep market drawdown in case of equity investment can end up in a big dent in investment value. Conservative investors have lower risk appetite and they desire to earn stable and consistent returns even if it means lower returns. Contrary to this, aggressive investors have higher risk appetite and desire to earn higher returns from their investment even though it means capital loss. Moderate investors wish to have the exposure of both aggressive as well as conservative investments and desire higher returns along with stability in their portfolio.

There are various investment options available for each of the above mentioned investors. Aggressive investors can invest in equity and equity-related instruments; conservative investors can invest in debt, fixed income or money market instruments; and investors willing to invest in both of them can invest their corpus blending both equity instruments as well as debt and fixed income instruments. In this article we are going to look at the investment options that a conservative investor has.

There are various low risk investment instruments available which deliver stable and consistent return to their investors such as debt mutual fund, bank fixed deposit, public provident fund, relief bonds, government securities, national savings schemes, post office monthly income scheme, among others. Out of all the options available we are going to take a look at two most popular investment instruments among conservative investors, which are debt mutual fund and public provident fund. Both of them have unique characteristics, benefits and limitations.

Debt Mutual Fund

Debt funds, depending upon their category, primarily invest in short, medium and medium to long-term debt instruments issued by private companies, banks, financial institutions, governments, etc. Debts are generally less risky than equities; however, they are subject to credit risk (risk of default) and interest rate risk. Debt mutual funds, also known as fixed income funds, invest significant portion of investors’ capital in fixed income instruments like government securities, debentures, corporate bonds and money market instruments. Ideally, debt funds are best suited for investors who aim for a regular income, stability in returns and capital appreciation with lower risk.

Debt mutual funds are less volatile and hence are less risky when compared to equity funds. Mutual funds offer various types of debt schemes according to the different objectives of the investors. As per SEBI, there are 16 different types of debt schemes offered by the mutual funds. Many investors invest in these debt mutual funds in order to bring stability in their portfolio. Since April 2019 there has been steady growth in asset under management (AUM) of debt funds. The AUM has increased from Rs 10.88 lakh crores to Rs 14.72 lakh crore as of July 2021 in income or debt-oriented schemes.

Types of Debt Mutual Fund Scheme

• Overnight Fund
• Liquid Fund
• Ultra Short Duration Fund  
• Low Duration Fund
• Money Market Fund
• Short Duration Fund
• Medium Duration Fund
• Long Duration Fund
• Dynamic Bond Fund
• Corporate Bond Fund
• Gilt Fund
• Gilt Fund with 10 year constant duration Floater Fund

Public Provident Fund (PPF)

Public Provident Fund (PPF) is a small saving scheme backed by the government. This is also called as savings-cum-tax saving instrument in India which enables investors to build a corpus while saving on annual taxes. PPF is a tax-efficient investment instrument which falls under the EEE category. EEE means exempt, exempt and exempt – all deposits made in this scheme are deductible under Section 80 C of the Income Tax Act and the accumulated amount and interest amount is also exempt from tax at the time withdrawal i.e. triple benefit to the investors.

In short, there is no taxation in case of PPF. The investment horizon of an investor should be at least of 15 years if he wishes to invest in PPF. Typically, one should invest in PPF in order to achieve long-term goals such as retirement, children’s education and marriage, etc. A PPF account is known to be one of the best ways for asset allocation towards fixed income instruments. The prevailing interest rate for Q2 (July-September) FY 2021-22 for PPF accounts has been fixed at 7.1 per cent per annum. The following table highlights the different characteristics of PPF and debt mutual funds.

PPF or Debt Fund

Now after understanding the characteristics of both debt mutual fund and PPF, let us try to understand which is better, with the following illustration. In case an individual wants to invest for his children’s education and invests in PPF, what is the corpus he can accumulate after 15 years? Similarly, what if he invests the same amount for the same timeframe in debt mutual fund? As an investor can invest a maximum Rs 1.5 lakhs in PPF, which he can claim as deduction under Section 80 C of the IT Act, then let us assume that he invests Rs 1.5 lakhs every year for 15 years. The current rate offered by PPF is 7.1 per cent per annum. Every quarter the Government of India decides the rate of interest.

We assume that it will change in the future also and will depend upon the overall interest rate environment and the macro economic situation. Therefore, we have taken the last 18 quarters’ average interest rate which will be available to an investor. This was 7.95 per cent. Based on this assumption we will calculate the future value of the investment. The following table shows how investment in PPF grows over the years and its value at the end of the 16th year.

Now let us calculate the return offered by some of the funds in the debt fund category with similar investment duration. Debt category such as long duration, medium to long duration, gilt, long duration, etc. invest in papers for longer duration. The average last 10 years’ return on these categories is 8.3 per cent. So, if an individual invests Rs 1.5 lakhs every year in a debt mutual fund which offers 8.3 per cent per cent, what will be the accumulated amount at the end of the 16th year? The following table shows the result

Thus, as seen from the above tables, if an individual invests Rs 1.5 lakhs every year in PPF then he can accumulate Rs 48.89 lakhs whereas if he invests the same amount in a debt fund he can accumulate Rs 50.52 lakhs at the end of the 16th year. Although the amount accumulated through investment in debt funds seems to be on the higher side, if we take the impact of taxation, PPF clearly wins. This is because an investor has to pay tax on gains made on investments in mutual funds. For the gain made on the investment in the first 12 years, he has to pay long-term capital gain tax with indexation benefit and for the last three years he has to pay tax at the slab rate of Income Tax. Quick calculation shows that the post-tax return offered by debt fund is lower than PPF. So does it mean that PPF is superior to debt funds?

Actually, both have their own benefits and limitations, as follows:

•  Withdrawals: One can withdraw an amount whenever he needs from a debt mutual fund in the event of requirement but in case of PPF no withdrawals are allowed during the first six years.

•  Taxation: In case of a debt mutual fund an individual cannot get any deduction on deposit of the investment amount but in the case of PPF an individual gets deduction under Section 80 C on deposit of the investment amount and also gets tax benefit during maturity as there is no tax levied on the maturity amount or the interest amount. In case of debt mutual fund, if capital gain arises, these are taxed as per the above mentioned rates in the table.

Conclusion

One should assess investment needs and objectives and then choose to invest in any of the above mentioned instruments. If you strive for tax efficiency with assured returns, PPF will be the best option to invest. Nonetheless, if you strive for higher returns with higher liquidity, then debt mutual funds will be best suited for your needs.