Insights

Why debt funds work better than FDs

June 5, 2015 . Sathyamoorthy N

If you are worrying about falling interest rates leaving you with no fixed income options, you are right – if your only fixed income option is bank Fixed Deposits (FDs). But did you know that falling interest rates can actually be a great opportunity in the debt market? Read on.

You may have often heard analysts say that there is an inverse correlation between bond prices and interest rates movement. Yes, that is where the opportunity lies. But first let us see what this relationship is all about.

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Let us assume that you had invested Rs. 100 in a 5-year bank Fixed Deposit at the interest rate of 10 per cent (annual interest payout) a year ago. You have received Rs. 10 as the first year’s interest payment. If the interest rate in the country fell by 1 per cent now, you will earn 1 per cent more than the market for the next four years. Now, your friend too wishes to get a 10 per cent interest, or Rs. 10 interest income on an FD; however, she cannot do that as the current rates are 9 per cent. But if she is willing to pay a price to generate a regular 10 per cent income for herself, she might want to buy it from you to secure her annual income.

Bank FDs cannot be transferred by you. But just for the sake of this example, let us assume that it is transferable. If your friend is keen to generate Rs. 10 as income today, she will have to invest at least Rs. 103 to generate Rs. 10 every year. Now that is the value of your Rs. 100 deposit today.

But if the deposit market is not very liquid, and not easily available in the market for sale, then Rs. 103 could be trading at an even slightly higher price as a result of demand. That means, if you sell it today, you get a capital gain (Rs. 3), over and above the Rs. 10 interest.

Bank FDs are not tradable in real life situations; hence, you can’t gain from it by selling it before the maturity. However, government bonds, Public Sector Unit (PSU) bonds, corporate bonds, and bank certificates of deposits are tradable instruments. As a retail investor, you can’t buy them in small quantities. You need to open an account with a primary dealer to buy and sell these bonds in large quantities. Besides, would you know when is the right time to buy or sell them? Also for every such sale after buying, you would have a tax impact, especially if you actively churn your portfolio.

Then how can you gain from the falling interest rates scenario? The answer, especially for retail investors, is debt mutual funds. Debt mutual funds invest in various fixed income instruments like bank Certificates of Deposits (CDs), Commercial Papers (CPs), treasury bills, government bonds (G-secs), PSU bonds and corporate bonds/debentures, cash and call instruments, and so on. These funds are classified based on varying time frames. That means you choose a different fund for short-term needs, and a very different one for long-term requirements. Needless to say, short-term funds tend to take low risk as you need your money in the near term, while longer-term funds take a bit of risk to generate returns over the long-term for you. These funds are classified based on the category and tenure of the underlying investment instruments.

As highlighted in the below chart, risk increases with the tenure of investment instruments. When there is a fall in the market’s interest rates, fixed income instruments with the longest tenure will gain more compared to the shortest tenure instruments. Hence, funds such as dynamic bond funds, long term income funds, and gilt funds are best placed to gain from the falling interest rate scenario as when rates fall, the price of their underlying instruments rise.

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In terms of taxation, debt funds score better than Bank FDs. If you hold your investments for more than three years, you just need to pay only 20 per cent capital gains tax (with indexation benefits). Since you take indexation benefits (that means adjusting the cost of your investment for inflation), your ‘real’ tax outgo will be far lower than the 20 per cent. Be it in terms of liquidity, superior returns or tax benefits, debt mutual funds score over passive bank deposits. Diversify your traditional debt holding with these schemes, based on your time frame of investment to take advantage of them.

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