Debt fund vs Fixed deposits
What are the options that a person has when he/ she chooses to invest in a debt instrument?
Well the choices are:
1. Bank fixed deposits: requires very little explanation.
2. Company fixed deposits not a big range of companies available, but a good option.
3. Company Bonds: Right from Tata to Sriram and Indiainfoline have listed debentures.
4. Government / Post office schemes: Google and you will find the details.
5. Mutual funds.
There are too many people who think mutual funds mean Equities. Well, it is not so, you can invest in a mutual fund and choose a debt scheme also! Here I am planning to write about mutual funds why and what kind of schemes to choose from.
I am too dumb (ok not clever) to know anything about interest rate cycles � and I am yet to meet somebody who is a good debt fund manager. So without wanting to risk playing the interest rate cycle, let me choose a fund which chooses assets of 6-24 months duration. Here the duration risk is dramatically reduced though some pundits may argue that we are at the higher end of the interest rate cycle. If you honestly believe that, you can put your money in a gilt fund or a dynamic bond fund.
Like I said, I am yet to meet a smart debt fund manager, so I will play the game by my rules.
What are the advantages of a debt fund over a fixed deposit?
I asked 4 fund houses for an answer one fund house had a good conversation about it, but no answer. One fund house sent me a completely irrelevant power-point presentation (did not have the heart to send it to the MD who is knowledgeable), one fund house has still not sent anything, and one fund house has not bothered to get back.
Most fund houses (and therefore the distributor) will send you a presentation on bank fixed deposit vs. Fixed Maturity Plan (FMP).
I am talking of a Bank Fixed deposit vs. Mutual fund Income scheme.
Let us look at the advantages of a mutual fund:
1. The single biggest advantage is you can choose how much to deposit and how much to withdraw.
2. You pay taxes only when you withdraw.
3. You can use it like a savings account put money whenever you want and withdraw when you want.
4. Even with interest rate cycles there is a good chance that you will get a decent return.
Historically it is easy to argue that very few debt mutual fund schemes have outperformed bank fixed deposits especially over long periods of time. This is right, but still, post tax the mutual fund returns are likely to be superior.
What makes an Income Fund (Growth Option) attractive?
Well the deferred tax bit!
In a bank fixed deposit of say Rs. 10,00,000 you will get a return of Rs. 100,000 if the interest rate prevailing is 10%p.a. However on this Rs. 100,000 you will pay income tax of say 30% – assuming tax at the higher end of the slab.
In a mutual fund assuming the same returns your GROWTH option NAV will be Rs. 11 i.e. your accumulation will be Rs. 11,00,000. Now if you did not need even one rupee out of this, THE WHOLE AMOUNT OF Rs. 11 lakhs is available for compounding in the next year.
Thus the amount available for compounding in case of a bank fixed deposit is 10,70,000 and it is Rs. 11,00,000 in case of a mutual fund. Now if you do this over a 15 year period the impact is HUGE.
Thus let us say a 44 year old man who has a surplus of Rs. 10,00,000 and has a high current income (which means he will not need the income from this Rs. 10 lakhs) should invest this amount in an income fund and leave it there till his age of 65!
What would have happened?
His corpus would have grown for 21 years without any interruption
Tax would be paid at the end of the period
The tax would be indexed capital gain instead of regular income tax
He could have added regularly without any worries
In a worst case scenario he could have withdrawn a small portion of the amount and paid a little tax.
Why is it that mutual fund distributors are not really pushing such schemes? My guess is old habits of pushing equities die hard!
use the calculator below to find out what I am saying….
http://freefincal.wordpress.com/2013/03/13/advantages-of-debt-funds-over-fixed-deposits-calculate-and-assess/
Saurabh Aggarwal
Sir , in case of f.d. 10.7 is fixed , want to know whether 11 nav in case of income fund is fix or will it fluctuate as market does ? If it fluctuates , assumption of rs.11 available for compounding shouldn’t be correct.
Sanjay
Bank FD are safer than mutual funds. For same reason, mutual funds also invest in bank CD. In addition to it, mutual funds have 2.5% annual management charge. Whereas bank FD has 30% tax on income. which comes to 3% if FD rate is 10%. And it will come to 2% if FD rate is 6.5%
What is your opinion about this? Are mutual fund investors taking more risk just to get almost same returns?
Jayren
Exactly, the calculation is not right. In MF 2.5% goes to AMC annually and you pay tax at the end (maybe nominal ) and in FD you pay 20% or 30% of interest – lets assume 8.5% – whch is 1.7% or 2.8% to the state as tax annually. So hardly a benefit here. With the linked FDs offered by banks liquidity and size of the amount as well doesnt matter. Good blog, but way off mark here. Good luck.
sneha
Wow Jayren, Saurabh and Sanjay, which debt fund charges 2.5% amc charges please?
debt funds range from 0.8 to 1.5% amc charges. Debt funds also benefit from interest rate fluctuations. If you are so worried about debt fund managers to play the change in interest rate game choose a fund with say 2 years duration – for a 20 year period. Liked Jayren’s last 2 lines. LOL.
pattu
Jayren, Sanjay,
MF returns are quoted by the AMC after deducing expense ratios. For someone in the 30% tax bracket even a debt fund with 7.5% CAGR will give a higher corpus than an FD with offering 10% returns over a 25 year period.
Here 7.5% is the outer limit. If the difference bet returns is smaller, the difference bet. corpus’s will be higher.
pattu
sneha,
BSL Gilt Plus Reg (gilt fund) has a ER of 2.67%!
Many debt funds charge 2.5% or thereabouts. However that is not the point.
akshat
The list of Mutual funds link is missing. Are income funds same as liquid funds ?
Saurabh Aggarwal
Sneha , i didn’t raised the question about debt funds expense charges , so i would like to be excused.
Pattu , i guess for over 20 year period equity funds are better then debt funds , if u can answer my above query , it will clear my doubts.
subra
no pattu Sneha’s point is relevant….people should assume a lesser rate for a debt fund by say 1.5% than a bank FD. Also from a risk point of view you should only consider a debt fund with a Duration of 2 yrs (ok Modified duration)…here the cost HAS TO BE LESS THAN 1.5%….
pattu
Saurabh,
Of course there will be NAV fluctuations (much lesser than equity MFs but non-zero), sharp spikes .. the whole works.
The example in the article represents 1 year return. Over a long period the average return or compounded annual growth rate (CAGR) should be considered. In all financial calculations involving MFs only this number makes sense.
The idea is not to compare debt vs. equity. Each has its own place in the portfolio. The idea is to highlight tax-efficient debt options resulting in more efficient compounding.
srk
few questions/doubts,
1.agreed that debt fund is better than FD so should one totally invest in debt fund or one should keep some amount in FD also.
2.if someone has big amount in FDs,company deposits so should he shift all in one debt fund or choose 3-4 debt funds and divide equally.
3.what happens if we withdraw before 1yr? how should tax be calculated?
4.is keeping money in debt mfs for long term(say 15yrs) safe or is there any risk?should we keep reviewing it yearly or no need to do that?
Thanks
Karthik
FDs in a bank with PAN deducts only 10%. And the remaining is compounded/reinvested. I agree that for a 30% guy, he has to pay 30%. But additional 20% he is taking from somewhere else and paying and not from this. So the compounding still effects to a greater extent. If we keep the rates constant and the modify the tax rate to 10% in the excel sheet, FD returns are always higher.
May be the the actual 20% value for every year can be summed up and can be considered as a total negative component in the final return of FD.
thenub
Karthik, nonsense. Money gone towards FD interest tax is gone. From this or that doesn’t matter!
pattu
@ Subra, Got it. Thanks.
Karthik
thenub, The excel sheet shows that compounding value of the returns. This a tax variable which is there makes the total difference in the returns. I had told in my message that money is going from somewhere. But the compounding is achieved.
Let me know whether you lose the compounding in FD just because you are paying tax from somewhere which you had to pay anyway.
subra
Karthik if your salary was 10L and the TDS was Rs. 2.3 lakhs, but the tax liability was 3L, and the 70,000 was paid by your dad…what would your Gross sal be and net sal be?
thenub is correct. This is like saying ‘my dad pays my tax, so I can accept a less paying job. LOL
sps
@Subra “Click here to know the list of debt schemes.” Did you miss the link or was the pun intended ! 😛
Sanjay
Sneha,
I agree to you. I had to go through “Key Information Memorandum” of 2 fund houses to know what they really charged as expense ratio. I came to know that Birla Sun Life charged 1.08% as expense ratio for FY 2011-12 for Dynamic Bond fund. And Taurus charged 0.52% for Short Term income fund.
Why expense ratio is not available on Value Research online?
Anyways, today I came to know that debt funds, unlike equity funds, don’t charge maximum possible expense ratio.
Thanks for info.
mangoman
These are the probable scene which will be witnessed in 2017 Monetary Review
RBI has reduced the CRR further and the CRR now stands at -3%. That means RBI will give an extra 3% of the banks total deposits to all the banks to overcome the liquidity issue.
SBI chairman Pramod Chapri so upset about RBI with the minus 3% CRR. He argues RBI should give unlimited money to the banks without any interest cost and the CRR itself is a idiotic banking practice followed centuries ago.
Repo Rate is reduced further and now stands at -4%. This means mango men ( You and me) have to pay 4% interest to keep your money in the bank deposit.
FICCI President Podi Godrej reportedly unhappy with RBI, that the repo rate is reduced only up to 4%. He wondered how industry will grow if the repo rate is -4. He wanted RBI to reduce the rates further.
Karthi Chidambaram ( he would become finance minister by then) expects RBI governor Ramarao to act responsibly to reduce rates further to -10%, so that poor Kumbani’s and Jehindra’s can eat atleast a square meal per day.
In a separate news, the CPI inflation touches 23% and the WPI inflation is at 12%. Taking note on this inflation figure PMEAC chairman sundarrajan says the WPI decreases by 0.00002% which actually gives room to RBI to cut the rates further. Further he noted that the price of jet engine reduces by 100%, which is what we need to look as a sign of cooling inflation.
Planning commission deputy Chamcha singh puts blame of rural people. He says rural people has become more arrogant these days and started eating decent food for 3 times per day which puts more pressure on the inflation. He also expressed dismay about the fact that poor people started drinking coffee everyday. He also says government is taking effective steps to arrest this trend.
Meanwhile real estate continues to thrive and the price of a single bedroom flat is 10 crore even though 100000 crores of apartments still vacant in the country.