In this article,
I try to put in place, a decision making framework to help individuals make
sound and informed investment decisions w.r.t Fixed Return Products. Since Bank
FDs and Debt Funds are two of the most popular fixed return instruments often
talked about in the same breath, it makes perfect sense for me to use these two
products as examples to illustrate a decision making framework.
Here’s a Step by Step Consideration of the key
factors involved:
Begin with gaining clarity on the Purpose of
Investing:
Fixed income
products are best suited for short term goals with a time horizon of less than
5 years. For longer time horizons, one must consider looking at equity. Hence
at the initial stage, one must be clear about the goal and the time in hand to
achieve that goal.
Once the purpose of investing is clear, one would look
at evaluating the popular options on the following parameters:
1. Returns (without accounting for the impact of taxation) – In terms of Returns before taxes, there may not be much to choose
between a Debt MF and a Bank FD of comparable duration. At times there could be
a difference in favour of Debt MFs but that too is very nominal.
2.
Tax Efficiency:
a.
Returns of Bank FDs are taxed
at one’s applicable income tax slab rate. In the case of Debt MFs, for a period
less than 36 months, the gains will be subject to STCG Tax and computed at the
applicable Income Tax Slab Rate (similar to Bank FDs). However, Debt MFs, if
held for a longer time period of 36 months or more, the gains will be subject
to LTCG Tax and will be levied at 20% after indexation. Indexation helps bring
down the tax liability drastically.
b.
In the case of Bank FDs, TDS
becomes applicable if the returns for the year exceed Rs.40,000/- annually.
Debt MFs, on the other hand enjoy the benefit of deferred taxation; No TDS
deduction is applicable on Debt MFs.
3.
Risk (Credit Risk,
Interest Rate Risk, Liquidity Risk):
a.
Credit Risk:
Bank FDs are insured to the extent of Rs.5,00,000/-. Any amount over
and above this is exposed to the risk of default. Debt MFs do not enjoy this
benefit of insurance. However, MFs are tightly regulated entities. Diversified
Debt Funds with highly rated underlying holdings, help counter the risk of
default by spreading the risk across holdings.
b.
Interest Rate Risk:
Bank FDs aren’t exposed to Interest rate risks. Open ended Debt
Funds, especially the ones with longer duration papers, are exposed to Interest
Rate Risk and hence can be highly volatile. Closed-ended funds such as FMPs do
not suffer from interest rate risk and hence their returns are more or less
predictable. Liquid and overnight Funds which carry very short term maturity
papers are also not exposed to Interest Rate Risk.
To effectively navigate through interest rate risks, one must choose
instruments with average maturity of underlying papers coinciding with one’s
intended holding period.
c.
Liquidity Risk:
Bank
FDs are liquid but liquidity here comes at a cost in terms of penalty levied on
the returns. On the other hand, Good Quality Debt MFs of reasonable size offer
very highly liquidity and redemptions do not attract any penalty.
Although I may
have quoted only two popular fixed return instruments here in my illustration,
this framework can be extended to a wider range of fixed return products
ranging from Post Office Deposits, Small Savings Schemes, Bonds, Debentures,
etc. Evaluation of these products against each of the above parameters and aligning
them with the expected time horizon will give investors clarity on picking the
best available alternative.