INDEXATION: Stacking the odds in favour of DEBT Funds

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Bank FDs or Debt Funds… What serves me better?

This is a question that strikes most individuals when they find themselves in a dilemma over making an apt choice.
 
Building a case for Prudent Investing:

In this article, I attempt to make a simple comparison between two popular fixed income instruments; Bank FDs & DEBT Funds; to help investors make informed choices. In the ensuing illustration I make a limited comparison by looking at the pre and post-tax returns offered by these instruments.

Here’s an Illustration:

Imagine you had invested Rs.1,00,000/- each (for a period of 5 Years) in a Bank Fixed Deposit and in a Comparable Debt Mutual Fund in F.Y. 2016-17 (1st April 2016). We look at their performance over a five year period, starting 1st April 2016 (F.Y. 2016-17) to 31st March 2021 (F.Y. 2020-21)

Let’s assume that the 5-Year FD, as promised, gave you a return of 7% p.a. (expressed as Annual Percentage Yield – APY); whereas the returns from the Debt Mutual Fund, as estimated, has been close to 8% p.a. (expressed as Annual Percentage Yield – APY). It is also assumed that throughout this period you were in the Highest Tax Bracket (30%).

Kindly note that the ROI for the 5-Year Bank FD as stated above has been expressed as Annual Percentage Yield (APY). The ROI stated by banks usually is in terms of Annual Percentage Rate (APR). To make it comparable to a Debt Mutual Fund, one should convert this APR into APY. This is needed because APR doesn’t take into account, the effect of compounding. In the case of Bank FDs, compounding happens on a quarterly basis and hence when converted to APY, the ROI goes up marginally. This conversion will make the comparison of Bank FDs with Debt Funds fairer and easier to understand. (Hey… by the way, It is okay if you didn’t quite get a hang of this bit.J Keep Reading…)

Looking at these instruments purely from an annual returns perspective, one would get a sense that there’s nothing much to choose between the two as the differential appears to be a paltry 1% p.a.

However, to get a better perspective, let’s do the math here:

PRE-TAX Returns:

Bank FD Maturity Amount at the end of 5 years: ₹ 1,40,255/- (A gain of ₹ 40,255/- @ 7%p.a.)

Amount accumulated in Debt MF at the end of 5 years: ₹ 1,46,933/- (A gain of ₹ 46,933/- @ 8%p.a)

In this case the Debt fund outperforms the Bank FD by a modest sum of ₹ 6,678/-

POST-TAX Returns:

The real difference can be gauged when one considers the POST TAX BENEFIT.

(Note: In arriving at the relevant figures, we haven’t considered statutory levies such as surcharge and cess, so as to reduce the ambiguity around the calculations and make them easier to understand.)

Bank FD: Bank deducts TDS on interest earned on FDs during the year if it surpasses a certain threshold limit. (Note: From F.Y.2019-2020 this annual limit has been increased from ₹10,000/- to ₹40,000/-). However, irrespective of whether TDS is deducted or not, one is liable to pay tax on interest earned during the year from Bank FDs, in accordance with their respective Tax Slabs.

In this case, at an applicable Income Tax Rate of 30% for the investor, the Net Annual Yield obtained from investing in the Bank FD is approximately 4.9% p.a.

Thus, after adjusting for annual taxes over the five year period, the net corpus accumulated at the end of 5 years in the Bank FD = ₹ 1,27,022/- (Tax Adjusted Figure)…

(Note: The actual amount on paper at the time of maturity may differ depending on whether TDS has been deducted or not. However this figure needs to be adjusted for taxation to understand the real benefit accrued to the investor).

DEBT MUTUAL FUND: Debt funds are liable to pay Capital Gains Tax on their gains. In this case since the investment duration exceeds three years, the gains will be categorized as Long Term and will be taxed @ 20% (with INDEXATION).

Leveraging DEBT Funds - the INDEXATION way!!!

INDEXATION benefit allows investors to revise their cost of acquisition by accounting for inflation. This is done with the help of the COST INFLATION INDEX (CII) chart* released and updated every year by the Government.

*COST INFLATION INDEX (CII) Chart:

 

With the benefit of INDEXATION factored into our computation, the difference between the returns of the two instruments stands out prominently…Let us see how…

Date of Acquisition of Debt MF units: 1st April 2016 (F.Y. 2016 – 2017)

Actual Cost of Acquisition of Debt MF units: ₹ 1,00,000/-

Indexed Cost of Acquisition = Actual Cost of Acquisition * (CII of Year of sale / CII of Year of purchase)


Actual Cost of Acquisition: ₹ 1,00,000/-

CII of the year of purchase (F.Y. 2016-17) = 264 (Refer to the CII chart above)

CII of the Year of sale (F.Y. 2020-2021) = 301 (Refer to the CII chart above)

Thus, Indexed Cost of Acquisition = 1,00,000 * 301 / 264 = ₹ 1,14,015/-

Date of sale of Debt MF units = 31st March 2021(F.Y. 2020-2021)

Proceeds from selling Debt MF units (Redemption Value) = ₹ 1,46,933/-

Total Taxable Capital Gains from the transaction = Redemption Value – Indexed Cost = ₹ 32,918/-

Since the holding period is greater than 3 years, the gains are liable for LTCG tax @20%

Thus tax payable on the gains = 20% * ₹32,918 = ₹ 6,584/- (excludes other statutory levies)

Note: Unlike Bank FDs, Debt MFs enjoy the benefit of deferred taxation whereby tax liability arises only at the time of liquidation of units.

Thus, after adjusting for LTCG Tax at the end of the five year period, the net corpus accumulated in the Debt MF  = Redemption Value – Tax Payable = ₹ 1,46,933 – ₹ 6,584 = 1,40,349/-

The Net Annual Yield therefore comes to approximately 7.01% p.a.

The Debt Fund in this case outperforms the Bank FD by a substantial amount i.e. ₹ 13,327/-

 
A Quick Summary of the Returns:


Pre-Tax Returns:

Difference between Bank FD & Debt MF in terms of Annual Percentage Yield = 1% (in favour of Debt)

Difference between Bank FD & Debt MF in terms of Accumulated Corpus = ₹ 6,678/- (in favour of Debt)

Debt MF outperforms Bank FD by a modest amount …

Post-Tax Returns:

Difference between Bank FD & Debt MF in terms of Annual Percentage Yield = 2.11% (in favour of Debt)

Difference between Bank FD & Debt MF in terms of Accumulated Corpus = ₹ 13327/- (in favour of Debt)

Debt MF outperforms Bank FD by a substantial amount as compared to the pre-tax returns…

Conclusion:


When compared at pre-tax levels, the difference between the two instruments appears to be modest, and hence there isn’t much to choose between the two. At post-tax levels though, the difference gets inflated twice over, compared to pre-tax levels, in favour of Debt MF.

It is important to note here that as the investment tenure gets longer, the outperformance of Debt MFs over Bank FDs amplifies to a point where it becomes too difficult to look the other way…

INDEXATION is what makes the difference here... With higher tax efficiency, INDEXATION helps you leverage the potential of your Debt MF Investments… thus playing THE REAL GAME CHANGER.

Therefore, for individuals in the highest tax bracket (as in this case), Bank FDs could prove to be very inefficient, in comparison to Debt MFs. In fact even at lower tax slabs, it would be prudent to check how each instrument fares under different taxation scenarios, before making your final choice.

Note: The comparison made here is limited to evaluating the pre and post-tax returns of the two instruments in consideration. With Bank FDs, one may not have much to evaluate before making a choice. With debt funds though, in addition to post-tax returns, the choice will depend on other aspects too such as credit risk, interest rate risk / duration, pedigree of the fund, size of the fund / liquidity, and a host of other qualitative as well as quantitative factors.


About the author


Deepak Rameshan, CERTIFIED FINANCIAL PLANNERCM, Dip TD, MMS.
Deepak Rameshan is a CFPCM professional, and has been working in the financial services domain for close to 13 years. He holds a Master’s Degree in Management Studies and a Diploma in Training & Development and has been actively engaged in Training & Content Development during this period. As a Personal Finance Enthusiast and an avid researcher of the subject, Deepak has delivered several Investor Awareness Workshops over the years covering areas such as Risk Planning & Insurance, Retirement & Goal planning, Tax Planning and a few other specialized areas. He takes keen interest in writing and has penned numerous articles for this blog, addressing some of the most relevant concerns that individuals face with respect to their finances.
“Financial Planning Standards Board Ltd. (FPSB Ltd.) is the proprietor of the CFPCM, CERTIFIED FINANCIAL PLANNERCM and marks outside the United States, including in India, and permits qualified individuals to use these marks to indicate that they have met FPSB Ltd.’s initial and ongoing certification requirements.”
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