Common parameters of selecting a fixed income investment are potential risk, expected returns and tax efficiency. Unaware of debt funds as a fixed income product, many investors opt Banks or small savings deposits. But, Debt funds if used properly and selected wisely can be a good alternative to other fixed income investments.
Common parameters of selecting an investment instrument are looking at potential risk, expected returns and tax efficiency. Once the goal to be achieved is finalised, the search for suitable investment option begins. It is recommended that when the goal is very near or you have a low risk appetite, you should select less volatile investment options. That is the reason why people tend to look only at the bank deposits or small saving schemes. We feel very safe keeping our money in the bank. But practically, these bank deposits are not that lucrative when it comes to taxation aspect. In fact this is not only the case with bank in particular but with all fixed interest instruments. Besides PPF or Tax free bonds, almost all fixed income instruments generate taxable returns. Debt mutual funds if used properly and selected wisely can be a good alternative to other so called safe instruments. There are three main benefits of investing in debt mutual funds:
1. Debt mutual funds are pure investment vehicle with a fixed, low and regulated expense structure. So whatever the fund manager generates out of the investments gets distributed among investors after deducting expenses.
2. Returns generated by mutual funds come under capital gain which has a special tax charge structure and is suitable to investors in higher income bracket.
3. Bond prices have inverse relation with the interest rates and debt mutual funds have all kind of products which one can use depending on interest rate scenario.
As you know, the interest rates in most of the debt investment options have been deregulated by the government. Gone are the days when you received fix rate of interest in PPF for the complete tenure. Almost all Post office savings rate are now reviewed and reset annually. Even savings account which used to give 4% fixed rate has been deregulated. The decision is left to the market forces to determine the interest rate offering. Now it becomes inevitable for the investor to optimise the overall return and look for other suitable investment options. And you won’t find a better alternative to mutual fund investments. If you understand the various types of mutual funds, it’s working structure and which fund to be used and when you can generate a good tax efficient return. Following are some examples and comparisons of some instruments which explain the advantage that debt mutual funds have.
1. Liquid/ Ultra Short term funds Vs. Saving account:
These funds invest predominantly in papers of very short maturities –largely in money market instruments. Investments in these are comparable to parking money in saving bank deposits. Both banks and mutual funds generate their returns from the same market i.e treasury market. And they actually generate almost the same return but differ in distributing those to account holders. This can be understood from the fact that some banks are offering rates of around 6-7% on their savings bank balance and others are offering just 4%. This is because of the management restrictions and expense structure of the product. So those account holders who are still earning lower rate on their savigs accounts need not change their bank. You can increase your money’s productivity by investing in liquid funds. Current account holders don’t get any interest in their account, so they can also use this product.
2. Fixed Maturity plans Vs. Bank Fixed deposit:
Fixed maturity plans are comparable to bank fixed deposits. Investors choose these when the intention is to lock in savings for a fixed tenure and earn higher interest. Both these instruments generate almost similar returns but the difference is on the taxation part. Interest on bank Fixed deposit is fully taxable , but if you invest in mutual funds FMPs with more than one year time frame then the maximum tax that you have to pay is lower of 10% on actual gain or 20% on indexed gain. As the tax rates are subject to indexation also, so many times it has been observed that returns received were entirely tax free.
3. Long term debt funds vs. PPF:
Now that the when PPF rate has been handed over to market forces, your portfolio requires active management and a combination of PPF and long term debt products. When interest rates start falling PPF rates will go down too. But your long term debt investments will help you generate more by playing with duration due to the inverse relation between interest and bond prices. More returns can be set off with the indexation benefit and thus less tax.
4. Mutual funds MIP vs. Senior Citizen Plan/ Post Office MIS
You may also reduce your tax outgo considerably by diversifying your regular return fully taxable investments into mutual fund MIPs. In many cases using systematic withdrawal plan in MIP has provided better tax efficient returns than Post office MIS.
5. Gold ETF Vs Physical gold
. This is not debt product but is considered as one of the safest investment option. Besides offering advantage of liquidity, authenticity, affordability etc. gold ETF has its tax advantages too. Profits from gold ETFs are taxed as short /long term capital gain in 12 months just like debt mutual funds, unlike profit out of physical gold which comes under long term capital gain only after 3 years of holding. Gold ETF’s also do not attract Wealth Tax.
Mutual funds are very tax efficient products. But they should be used with caution and under some guidance. Wrong product chosen at wrong time and without paying attention to your reason for investment, has the potential to destroy your savings and overall returns. So discuss with your planner/advisor, decide your goals and requirements and design the required portfolio.
The author is a member of The Financial Planners’ Guild, India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.