Long Term Income Funds are better investment options than FDs over a 3 year horizon.
A vast majority of risk averse investors prefer bank fixed deposits to debt mutual fund schemes. Perception of risk and lack of financial awareness are the contributing factors. For investors who are willing to sacrifice the comfort of guaranteed returns, long term income funds are better investment options than fixed deposits over a tenure of three years or more. While banks are offereing around 7-8% interest rates for a 3 year term deposits, top long term income funds have given returns of 9.5 – 10.7% over the last 3 year period. Further over tenures of three years or more, debt funds enjoy tax advantage over fixed deposits due to the long term capital gains tax with indexation. If we add the difference in pre-tax returns and the tax benefit, the post tax returns of long term income funds has been substantially higher than the bank fixed deposits.
Returns of top long term income funds
Over a three year tenure top performing long term income funds have given 1.5 – 2% higher returns compared to fixed deposits. On 1 lac investment the returns from income funds over a three year investment horizon would be 2,000 to 6,000 higher compared to fixed deposits on a pre-tax basis. The chart below shows the trailing three year annualized returns of the top income funds.
Outlook for Long Term Income Funds
We have been in the grip of high interest rates for a long time due to stubborn inflation. The 10 year Government Bond yield is now at 6.513%. Bond prices have an inverse relationship with interest rates. As interest rate goes down bond prices increase, leading to higher potential returns from long term income funds.
Income Funds are not risk free
It is important that investors understand that though income or debt funds are comparatively safer because they invest in government securities only, still they the following nominal risks:
Interest Rate risk :
If interest rate goes down bond prices and returns will increase. Conversely, if interest rate goes up bond prices and returns will decrease. In the context of India’s macro-economic outlook and the interest rate environment, the probability of interest rate going up is very low.
if the average maturity of the bonds in the portfolio is longer. Long term income funds typically have longer maturity bonds in their portfolio, as we will see in the table below.
If the credit rating of the bond worsens the bond price will decline and the returns will be lower. As far as credit risk is concerned, the top long term income funds have high quality bonds in their portfolio, as we will see in the table below.
The holding period of long term capital gains is now 3 years. If the holding period is less than 3 years, then the returns will be taxed as per the income tax rate of the investor. If the holding period is more than 3 years, long term capital gains tax of 20% will apply. However, indexation benefits are allowed for calculation of long term capital gains.
HOW DEBT MUTUAL FUNDS ARE BETTER THAN BANK FDs:
FDs offer assured returns but debt funds offer higher post-tax returns
When you place an FD, the interest rate gets locked. It’s currently 8 to 9% for FDs above a year. You can accurately predict the amount of money you will have at the time of maturity even before you start the FD.
Debt funds also provide 8-9% returns when you look at the historical debt funds’ performance. While debt funds are mostly safe investments, there could be some volatility due to the fluctuations in interest rates. Scripbox selection methodology, for example, takes this into account.
Taxes significantly affect income from FDs
The income you earn from FDs and debt funds is categorised differently You earn interest from FDs while debt funds give you capital appreciation or dividend.
While interest from Bank FDs is always taxed at your maximum rate, Debt funds attract almost nil tax after 3 years and lower tax between 1 and 3 years. Upto 1 year the tax impact for both is similar.
What hurts an FD investor even more is that they have to pay taxes on accrued interest every year (even if you haven’t actually received it in your hands) and therefore the amount of money which compounds is less.
Let us take an example of Rs 1 lakh being invested simultaneously in FD and Debt Mutual Fund for four years on 1st January, 2013 (AY 2013-14) for four years with their maturity on 1st January, 2017.
The following table shows that debt mutual fund scores over bank FD by a wide margin.
Debt funds provide better liquidity or easy access to your money Withdrawing from FDs
If you need your money back before the maturity of the FD, you will receive a lower rate of interest and also pay a penalty.
- Some banks allow you to break your FD in part but most require you to withdraw the whole amount. If you have INR 1 lakh deposit, but you only want INR 20,000, you have to break the entire FD.
- Interest Rate on premature withdrawal = Interest Rate applicable for actual period of FD as per the rates prevalent at the time of investment – 1%
- The penalty for withdrawing is 0-1.5% of the invested amount viz. Rs 0-1500 for a one lakh deposit.
Withdrawing from Debt Funds
With debt funds, you have full liquidity for your investments.
- You can withdraw any amount you wish to from your total debt fund value whenever you want. The money comes into your bank account in 3-4 working days.
- The return you get is the amount earned by the fund during the period you were invested. There is no complex formula.
- Some debt funds will charge you an exit load if you withdraw within a certain period of time. This is usually small (0.25% – 0.5%) and only for periods less than a year.
Burden of tax-related paperwork is higher for FDs
Since you must declare and pay taxes on interest income from FDs every year, you have to maintain records, compute your interest income and file taxes accordingly. This gets even more complicated in the case of premature withdrawals where you may already have paid tax but the income you finally get is lower.
As you can see, with debt funds, you get superior returns post-tax, high level of liquidity, and safety of capital compared to FDs. These make debt funds an Excellent alternative to keeping your money in Bank FDs.
The world has changed in many ways over the past couple of decades. Lifestyles have changed, dreams and aspirations have changed and even how the economy functions has changed. Fixed deposits may not be enough anymore, especially for those who have joined the workforce in the past few years and have begun investing recently. For young investors, mutual funds would be a better option than fixed deposits.