When it comes to different investment options in India, fixed deposits (FD) top the popularity charts. It is not unusual to find people having invested in them for all kinds of needs, be it those for the longer-term or to meet imminent needs. Unfortunately, this often means ignoring four potent dangers faced by FDs.
Four Limitations Of Fixed Deposits
Keeping up with interest rates
Interest rates keep changing from time to time and with them, interest rates for fresh FDs. However, the interest rate offered for a particular fixed deposit at the time of investment remains the same during the FD term. For instance, a 3-year FD providing 8% annual interest will continue to provide the same interest rate even if the interest were to increase or decrease the next year.
However, the investor confronts a challenge when the FD matures and the investor needs to re-invest it. During a period of falling interest rates, the investor needs to hunt for the best rate for the period sought. On the other hand, during a period of rising rates, there is the danger of the investor losing out on getting the best rate.
The interest income from your FD is taxable according to your tax slab. Also, there is a provision of tax deducted at source (TDS) if the interest income is more than Rs 10,000 a year. So, if you are in top tax slab of 30%, and your bank fixed deposits earn 8% p.a, they effectively pay 5.60% p.a.
After getting hit on the tax front, there is the bite of inflation that you need to reckon with. If the annual inflation rate is 6% in the above example, you are actually losing money. The truth is that this is exactly what happens to millions of Indian FD investors.
Limited access to money
The other issue with FDs typically crop up when money is needed quickly in case of an emergency. You can’t make a premature exit from it in case of an emergency without losing out on some of the interest income.
Clearly, there is a compelling case for looking for an alternative to FDs, especially options that would effectively deal with its limitations. It is here that open-end debt mutual funds, offered by mutual funds check all the boxes. Thus, they present themselves as a viable alternative to FDs. Here is a brief primer about them.
Debt fund primer
Broadly speaking, a debt mutual fund, or debt fund, is a mutual fund scheme that invests in fixed income instruments. They include investments like bonds, corporate debt securities and money market instruments, among others, that offer capital appreciation.
Investors seeking low risk investment that provides regular income, are likely to find it attractive. Debt funds are low on volatility and, hence, are lower risk investments compared to equity funds that invest in equities.
With this background on debt funds, let’s take a look why they have an edge over FDs.
The Debt Fund Edge
Exploit interest rate movements
A debt fund’s performance depends on the interest rates of its debt investments and any upgrade or downgrade in their credit rating. Market prices of debt securities change with movements in interest rates.
Let’s assume, your debt fund owns a security that yields 10% p.a. If interest rates fall, new debt investments that hit the market would typically offer lower interest rates. At the same time, this would result in appreciation of your debt fund’s investments. Consequently, the value of your investments will appreciate thanks to an enhanced net asset value (NAV) of your debt fund. Unlike FDs, you don’t have to track the interest rate movements. Expert fund managers do it for you and in a way that you benefit from them.
Inflation combat prowess + tax efficiency
One of the major reasons debt funds have an edge over traditional fixed deposits is inflation indexation benefits. This supplements the advantage of debt funds being able to exploit interest rate movements. Here is how it works.
If you invest in debt funds for a relatively longer period like 3 years or more, you receive inflation indexation benefits. This means that the cost of acquiring units gets enhanced after factoring in the impact of inflation during the period of investment. As a result, the taxable capital gains become lower. Additionally, you benefit from 20% long term capital gains tax rate. This is lower than the tax paid by those in the highest tax slab of 30%.
Tax free dividends in the hands of the investor
Debt funds can be a great source of tax free regular income in the form of dividends. They are exempt from tax in the hands of investors. At the same time, the fund needs to pay a Dividend Distribution Tax (DDT) of 28.325%. This is applicable for individuals and Hindu Undivided Families (HUF).
Easy access to money
In case of open-end debt funds, your investment doesn’t get locked in during the investment tenure. You can liquidate the debt mutual fund units easily. When you redeem such units, the amount typically gets credited to your bank account within 2-3 days from the date of redemption.
You may also opt for Systematic Withdrawal Plan (SWP) if you want to liquidate the investment over regular periods of time. This is quite useful when you want to use the debt fund as a source of regular income. With the help of SWP, you can get a fixed sum of money regularly on a predefined date. This facility ensures that you get to access your money easily even as the remaining part of the investment continues to grow well.
A wide range of choice
When it comes to debt funds, there is a wide variety to choose from. It is classified on the basis of the type of instruments it invests in and the duration of the instruments in the portfolio. You can opt for a debt fund according to your requirement.
Here are some of the debt fund categories.
Types of Debt Funds
They invest primarily in debt instruments of various maturities. These investments are in line with the objective of the funds. The balance is invested in short-term investments such as money market investments. These funds generally invest in investments with medium to long-term maturities. This means that this can be actively considered for needs that are 3-4 years away.
Short Term Funds
A short-term or short tenure debt fund is a fund that primarily invests in debt investments with shorter maturity or duration. It invests primarily in debt and money market investments and government securities. They work quite well to meet needs that are going to arise in about two years.
Floating Rate Funds
They are a variant of income funds that try to minimise the fluctuations in returns. Floating rate funds do this by investing in debt securities with floating rates of interest. This debt fund category is useful during times of reasonably rapid changes in interest rates.
The word ‘Gilt’ implies government securities. A gilt fund invests in government securities of various tenures issued by central and state governments. These debt funds generally do not face the risk of default or the risk of invested money not repaid, since the issuer of the securities is the government itself. Gilt funds have the highest risk among debt funds due to the long duration of such funds and are suitable for those who can deal with volatility.
Dynamic Bond Funds
Dynamic Bond Funds (DBFs) are debt funds that invest in debt securities of different maturities. They are actively managed. The portfolios of investments are changed dynamically depending on the changes in interest rates. In other words, such funds can exploit the advantage of interest rate movements.
To conclude, open-end debt funds allow mutual fund investor to work around significant limitations of FDs. It’s time for investors to actively consider this attractive alternative and benefit from it.
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