What are the options that a person has when he/ she chooses to invest in a debt instrument?
Well the choices are:

1. Bank fixed deposits:  requires very little explanation.

2. Company fixed deposits  not a big range of companies available, but a good option.

3. Company Bonds: Right from Tata to Sriram and Indiainfoline have listed debentures.

4. Government / Post office schemes: Google and you will find the details.

5. Mutual funds.

There are too many people who think mutual funds mean Equities. Well, it is not so, you can invest in a mutual fund  and choose a debt scheme also! Here I am planning to write about mutual funds  why and what kind of schemes to choose from.

I am too dumb (ok not clever) to know anything about interest rate cycles � and I am yet to meet somebody who is a good debt fund manager. So without wanting to risk playing the interest rate cycle, let me choose a fund which chooses assets of 6-24 months duration. Here the duration risk is dramatically reduced  though some pundits may argue that we are at the higher end of the interest rate cycle. If you honestly believe that, you can put your money in a gilt fund or a dynamic bond fund.

Like I said, I am yet to meet a smart debt fund manager, so I will play the game by my rules.

What are the advantages of a debt fund over a fixed deposit?

I asked 4 fund houses for an answer  one fund house had a good conversation about it, but no answer. One fund house sent me a completely irrelevant power-point presentation (did not have the heart to send it to the MD who is knowledgeable), one fund house has still not sent anything, and one fund house has not bothered to get back.

Most fund houses (and therefore the distributor) will send you a presentation on bank fixed deposit vs. Fixed Maturity Plan (FMP).

I am talking of a Bank Fixed deposit vs. Mutual fund Income scheme.

Let us look at the advantages of a mutual fund:

1. The single biggest advantage is you can choose how much to deposit and how much to withdraw.

2. You pay taxes only when you withdraw.

3. You can use it like a savings account  put money whenever you want and withdraw when you want.

4. Even with interest rate cycles there is a good chance that you will get a decent return.

Historically it is easy to argue that very few debt mutual fund schemes have outperformed bank fixed deposits especially over long periods of time. This is right, but still, post tax the mutual fund returns are likely to be superior.

What makes an Income Fund (Growth Option) attractive?

Well the deferred tax bit!

In a bank fixed deposit of say Rs. 10,00,000 you will get a return of Rs. 100,000 if the interest rate prevailing is 10%p.a. However on this Rs. 100,000 you will pay income tax of say 30% – assuming tax at the higher end of the slab.

In a mutual fund assuming the same returns your GROWTH option NAV will be Rs. 11  i.e. your accumulation will be Rs. 11,00,000. Now if you did not need even one rupee out of this, THE WHOLE AMOUNT OF Rs. 11 lakhs is available for compounding in the next year.

Thus the amount available for compounding in case of a bank fixed deposit is 10,70,000 and it is Rs. 11,00,000 in case of a mutual fund. Now if you do this over a 15 year period  the impact is HUGE.

Thus let us say a 44 year old man who has a surplus of Rs. 10,00,000  and has a high current income (which means he will not need the income from this Rs. 10 lakhs) should invest this amount in an income fund and leave it there till his age of 65!

What would have happened?

His corpus would have grown for 21 years without any interruption
Tax would be paid at the end of the period
The tax would be indexed capital gain instead of regular income tax
He could have added regularly without any worries
In a worst case scenario he could have withdrawn a small portion of the amount and paid a little tax.

Why is it that mutual fund distributors are not really pushing such schemes? My guess is old habits of pushing equities die hard!

use the calculator below to find out what I am saying….

http://freefincal.wordpress.com/2013/03/13/advantages-of-debt-funds-over-fixed-deposits-calculate-and-assess/

Related Articles:

Post Footer automatically generated by Add Post Footer Plugin for wordpress.

  1. Subra-Ji

    I know you don’t give a direct advice.
    But I will try to extract an answer/opinion.

    For a couple aged 35, looking for a conservative and safe option for retirement, would you advice the following:
    – PPF (done)
    – POMIS (Post office monthly income scheme)
    Will you advice opening a POMIS account and keep on investing till max limit of 9L is reached? To make 9L in that account for a working couple will take some time.

    Kindly advise.

  2. enlightening post . i like to add one more point in favor of debt mf , particularly liquid mf for short duration , say 6 months or so. the interest rate of selected liquid funds would be better than comparable fd interest rate, plus unlike fd, for earlier need, one has not to worry about penalty of @ 1% point (as common for premature d encashment of fd.)

  3. The article is well written and very easy to understand as it avoids financial jargon words. I congratulate you! I have a point to add about following section of the article –

    ================================================

    What makes an Income Fund (Growth Option) attractive? Well the deferred tax bit! In a bank fixed deposit of say Rs. 10,00,000 you will get a return of Rs. 100,000 if the interest rate prevailing is 10%p.a. However on this Rs. 100,000 you will pay income tax of say 30% – assuming tax at the higher end of the slab. In a mutual fund assuming the same returns your GROWTH option NAV will be Rs. 11 i.e. your accumulation will be Rs. 11,00,000. Now if you did not need even one rupee out of this, THE WHOLE AMOUNT OF Rs. 11 lakhs is available for compounding in the next year. ==================================================

    Apart from compounding, even if you require the grown money in Mutual fund, your tax liability is much less than what you incur on FD interest. Let me explain how. My assumption, investor would continue with his debt fund investment perpetually – I mean investor does not require Principal amount and requires only growth amount. Continuing with your example, if one invests 10 lakhs in FD and get interest at 10% PA, the whole amount of 1 lakh by way of interest is added to your taxable income. However, if investor keeps the money in open ended debt MF scheme that gives same 10% growth for a year, if investor chooses to withdraw the 1 lakh growth, only 9090 of that amount would be added to taxable income. Here is how – Lets say that NAV of MF was 10 rupees when scheme was purchased (again this is for simplicity – NAV can be anything – the calculation does not change), investor got 1 lakh units. After 1 year, NAV grows 10% to 11 rupees. To withdraw 1 lakh, investor would have to redeem only 9,090.90909091 units – on each unit growth was 1 rupee hence total taxable growth amount would be 9090 rupees only!

  4. This article sugarcoats MF Debt schemes and almost makes you feel guilty about FDs.
    However, I think their comparison is not as black and white as it may seem.
    I am not saying the virtues of deferred tax is not true…it is.
    But before you dump all your FD, try to get around all aspects, for ex, do you know that return from debt fund can be negative too

    Read this article for a differnt perspective,and then place your eggs
    http://www.moneylife.in/article/right-time-for-debt-schemes/39763.html

    Here is one line from the article to pique your interest
    “In the next period—from October 2003 to October 2005—interest rates remained flat at 6%; the top 20 debt schemes returned an annualised 4%. The bond scheme universe was able to return just 1% in this period. As many as 10 schemes reported negative returns.”

  5. Subra Sir, corporate debt investments are black boxes, specially in case mutual funds. I would stay clear of such instruments rather Govt’s PPF & EPF are superior options.

Leave a Reply