Debt Mutual Funds offer better tax adjusted returns than fixed deposits

When coming to investing in debt, the traditional approach is to choose bank fixed deposits (FD).

Despite the increased penetration of Mutual Funds (MF) into the mainstream investing, still the bulk of the investments are with bank FD.

However, the reducing interest rate scenario and the taxation constraints are making a strong case for debt MF as the best alternate choice for this category of investors. Though, in terms of safety and liquidity, the risk could be differentiated upon these two instruments.

From the safety and convenience perspective, the bank FDs take the pole position. Also, it fits well into the psyche of the savers and investors as their presence in the neighborhood augurs well.

With the improved regulations and rules, the solvency of the banks has increased, and defaults are almost negligible.

This makes for a conservative investor to invest and forget while be assured of the guaranteed returns through the interest payout which is well defined at the beginning itself.

This is not the case with any debt MF, where the investors return varies with the instruments opted by the fund and the timelines of the investment.

The returns are market linked as bond yields fluctuate due to the change in interest rate and more importantly, investors are exposed to default or other credit risk events to the extent of exposure to the entities.

There have been such events of precedence and recent events in the space of Non-Banking Financial Institutions (NBFC) have only spiked the default risk creeping up even starker.

Though, not all funds are impacted but the possibility of such occurrence of risk is not completely ruled out. Moreover, all funds are governed by regulations issued by the Securities Board of Exchange in India (SEBI) and thus have to disclose the risk profile of instruments being held by these funds.

Despite best efforts of the regulator there had been cases earlier in the steel and automobile sector and now with the financial institutions where due to the default or downgrades, the investors' faced losses in most cases and an overall wipeout in some cases.

The bank deposits are prone to default if the bank turns insolvent and only deposits to an extent of one lakh rupees are insured for. But this has been a very rare event except for some co-operative and local banks, large scale commercial bank defaults have not impacted the depositors in the earlier events. That provides for a higher safety but a lower interest return for the deposit investors.

Unlike equity MF, debt MFs provide liquidity in a day's notice i.e., redemption proceeds hit the bank account the very next day. The bank FDs too have a similar timeline of receiving funds in case of a maturity or redemption.

But, in FD's case, there would be a penalty imposed for a pre-mature redemption and so is the case of debt MF an exit load depending upon the fund. Unlike FDs, the exit loads in debt MF tend to differ with the tenure of investment and type of fund.

Taxation is where investors could greatly benefit and thus enhance their overall return. Interest income is taxed as per the individual tax slabs and a higher interest payout for an individual at a higher tax slab, considerably shrinks the real returns they enjoy on these instruments.

And then there's tax deducted at source (TDS) which would be automatically deducted by the bank in a FD wherever the total interest exceeds 10,000 every fiscal and could only be claimed at a later time if not applicable for the individual.

In a debt fund, the taxation is treated differently and considered on the lines of capital gains. So, for units held up to 36 months is considered as short-term and beyond are treated as long-term capital gains (LTCG).

The taxation for short-term is as per the individual tax slabs but LTCG are taxed at 20 per cent with indexation or 10 per cent without indexation. Indexation could enhance the returns in a higher inflationary scenario thus benefiting the investor.

The possibility of higher returns though at a measured risk along with taxation advantages would benefit the investor of debt MF with a medium to long-term horizon.

However, while opting for the type of debt fund, the investor needs to consider beyond returns and should give higher priority for the risk associated with instruments invested. It should also suit the timelines of the goal one is investing for so as to benefit best out of the investment.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)