Debt mutual funds or bank fixed deposits?- Business News

Debt mutual funds or bank fixed deposits?

Ashok Kumar        Last Updated: June 21, 2011  | 13:37 IST

Over a period of one year there has been a steady rise in deposit rates, which have risen to as high as nine per cent plus. The reason for the high deposit rates is the prevalence of a high interest rate regime caused by a liquidity crunch and rising inflation, which warranted action by the Reserve Bank of India (RBI).

Further, given that crude oil prices are hovering above $100 per barrel there are expectations that interest rates could further rise by another 50 basis points from the existing levels. This may happen in two tranches though.

Moreover, due to the tight liquidity conditions faced by banks in the short term banks have been constrained to raise their interest rates to make investments in fixed deposits (FDs) more attractive.

In the race to attract investors, mutual fund houses also offer investors products that suit their needs like Liquid Funds , Ultra Short Term Liquid Funds, Short Term Bond Funds and Fixed Maturity Plans (FMPs), which hold out the hope of being able to provide investors with a return of about 9 to 10 per cent.

So, what factors should a debt investor (which is what most Indian investors predominantly are) weigh while making a choice between an FD and a debt mutual fund? The biggest plus that a bank FD has over a debt mutual fund (short term) is that they give a fixed rate of return. However, the post- tax returns are much lower as the income earned by way of interest is clubbed with the income of the individual and taxed. Also, if the money is withdrawn before the lock-in period a penalty is charged for early redemption. Thus, for most individuals falling in the highest tax bracket, FDs are not the most lucrative option.

The tax efficiency of debt mutual funds puts it at an advantage, making it an appealing investment option as the tax levied by these funds on capital gains is much lower than that of FDs.

These funds are fraught with risk as the returns are linked to fluctuations in interest rates and the resultant market volatility.

Also, debt funds offered by various AMCs offer high amounts of liquidity and thus suit the needs of those investors who want to park surplus funds for a specific time frame or are yet to make a provision for their financial goals without sacrificing on the opportunity of making money even in that short period.

However, in addition to choosing a debt fund that is ideal for the tenure one chooses to remain invested, investors must also keep in mind certain factors while making a selection.

Investors must choose the fund which has the least expense ratio as the portfolios would be identical to a very large extent.

Also, consider whether the fund house charges any exit load, as some fund houses have a minimum period during which one must remain invested. Investors need to keep an eye out for funds which have a lower average maturity and duration as they are less sensitive to interest rate changes.

So, given the likely rise in interest rates, investors in a higher tax bracket can invest in debt funds to get an edge over FDs in terms of net of tax returns.

(Ashok Kumar is promoter, theIPOguru. com & director, Lotus Knowlwealth)

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