Fixed Match:Tilting Against FDs

With interest rates on bank fixed deposits(fds) touching 9-9.5%, 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%.

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.

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 compar- ing 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% compared to the average one-year pre-tax return of 5.65% 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% and not 9-9.5%, as the FD rates stand now. The top 50 income funds gave a return of 7.5% and above during the period (July 5, 2010 to July 4, 2011).

Fixed maturity plans (FMPs), which are close-ended debt funds, gave an average return of 5.5% 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 annu- alised basis, giving higher pre-tax return than bank FDs.

Among income funds, Escorts Income Fund-Growth gave a return of 17%, Religare Credit Opportunities 13.5%, Sundaram Select Debt-STAP 13.4% and Tata FIPF C3-Regular 12% in the oneyear period mentioned above.

Among FMPs, ICICI Prudential S.M.A.R.T-Series H gave a return of 16% and ICICI Pru S.M.A.R.T-Series F gave a return of14.6% 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.

In a debt fund, the long-term capital gains tax (earnings from a fund held for one year and above) without indexation is 10%, while it is 20% 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 infla- tion 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%, while that from liquid funds is taxed at 25%.

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% tax on their earnings stand to gain more from tax-efficient debt funds than those in the 10% tax bracket, which is evident from the indexation benefit table.