For fixed income, investing in debt funds better than fixed deposits
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Debt funds investment better than FDs

If you are seeking fixed income, don't jump on to the FD bandwagon just yet. Tax adjustments could make debt funds better investment options.

With interest rates on bank fixed deposits (FDs) touching 9-9.5 per cent, are you in a fix whether to allocate a part of your investible surplus to the income fund your financial planner has advised or are you instead tempted to park your money meant for fixed income investment in bank FDs?

In the current scenario, most risk-averse investors would opt for FDs. The lure of near double-digit annual returns with almost no risk is too hard to resist given that the average return given by the top 50 income funds in the past one year has been just 8 per cent.

Income funds are debt funds offered by mutual funds that seek current income rather than growth of capital. They invest in stocks and bonds that pay high dividend and interest.

If you have based your investment decision on the above premise, you may have erred not on one but two counts. First, you are comparing present FD rates with the past one year's performance of debt funds. Ideally, you should compare debt fund returns with FD rates a year ago. Second, the returns compared above are pre-tax, which may give you a completely wrong picture.

"Considering the overall impact on real returns due to indexation benefit, a debt fund is definitely a better alternative to FDs."
Yadnesh Chavan
Fund manager, fixed income, Mirae Asset Global Investment
Srikanth Meenakshi, director, Wealth India Financial Services, says often investors commit the mistake of comparing current FD rates with the past performance of debt funds.

"Ideally, debt fund returns should be compared to FD rates prevailing at the start of the period of comparison," he adds.

For example, if you are comparing the past one year's performance of a debt fund, that is, from July 2010 to June 2011, you should compare it with FD rates prevailing around July 2010 and not the current rates.

Let us see how it works in reality. Around July last year, bank FD rates were 7-7.5 per cent compared to the average one-year pre-tax return of 5.65 per cent as on July 4, 2011, from income funds. If you had invested in a one-year FD around that time (July 2010), your pre-tax return would have been 7-7.5 per cent and not 9-9.5 per cent, as the FD rates stand now. The top 50 income funds gave a return of 7.5 per cent and above during the period (July 5, 2010 to July 4, 2011).

Mutual Funds turn to debt schemes to tackle high interest rates

Fixed maturity plans (FMPs), which are close-ended debt funds, gave an average return of 5.5 per cent during the July 2010-June 2011 period. FMPs are touted by fund houses as good alternatives to FDs because they are more tax efficient and carry a lower risk.

While we compared the average return of debt funds with that of FDs, there are debt funds which have seen double-digit appreciation in their net asset value on an annualised basis, giving higher pre-tax return than bank FDs.

Comparing present FD rates with the past performance of debt funds is a common mistake committed by retail investors.
Among income funds, Escorts Income Fund-Growth gave a return of 17 per cent, Religare Credit Opportunities 13.5 per cent, Sundaram Select Debt-STAP 13.4 per cent and Tata FIPF C3-Regular 12 per cent in the one-year period mentioned above.

Among FMPs, ICICI Prudential S.M.A.R.T-Series H gave a return of 16 per cent and ICICI Pru S.M.A.R.T-Series F gave a return of 14.6 per cent during the same period.

TAX IMPLICATIONS

After adjusting for income tax, returns from debt funds would be better than those from bank FDs. But before we go into the post-tax returns, we would like to discuss the rules related to tax liabilities on debt funds.

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In a debt fund, the long-term capital gains tax (earnings from a fund held for one year and above) without indexation is 10 per cent, while it is 20 per cent with indexation. Short-term capital gains tax is deducted according to your income tax slab.

In indexation, the cost of investment is raised to account for inflation for the period the investment is held. This is done by using a cost inflation index number released by the central tax authorities every year.

Dividend income from debt funds other than liquid funds is taxed at 12.5 per cent, while that from liquid funds is taxed at 25 per cent.

However, the interest earned on FDs is added to the total income of a person and then taxed according to his tax slab. Also, if the total interest earned on all your FDs in a bank is higher than Rs 10,000 in a financial year, the bank will deduct tax at source (See table Tax Outgo).

The indexation benefit table clearly shows that despite FD rates being higher than the returns from debt funds, post-tax gains are higher in case of debt funds.

"Considering that the overall impact on real return due to the indexation benefit is significant, a debt fund is definitely a better alternative to fixed deposits in the long term," says Yadnesh Chavan, fund manager, fixed income, Mirae Asset Global Investments Private.

Investors who pay 20-30 per cent tax on their earnings stand to gain more from tax-efficient debt funds than those in the 10 per cent tax bracket, which is evident from the indexation benefit table.