Are Debt Funds better than Fixed Deposits?

By: Neha Wadhwani and Mayank Pise

If you’re worried about falling interest rates leaving you with no fixed income options, you’re right but only if your only fixed income option is bank Fixed Deposits (FDs).

But did you recognize that falling interest rates can actually be a good opportunity within the debt market?

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

Let us assume that you simply had invested ₹10000 during a 5-year bank Fixed Deposit at the charge per unit of 10 percent (annual interest payout) a year ago. You have got received ₹1000 because of the first year’s interest payment. If the charge per unit within the country fell by 1 percent now, you may earn 1 percent over the marketplace for the following four years. Now, your friend too wishes to urge a ten percent interest, or ₹1000 interest income on an FD; however, she cannot do this because the current rates are 9 percent. But if she is willing to pay a price to get an everyday 10 percent income for herself, she might want to shop for it from you to secure her annual income.

Bank FDs cannot be transferred by you. But only for the sake of this instance, allow us to assume that it’s transferable. If your friend is keen to come up with ₹1000 as income today, she’s going to invest a minimum of ₹10300 to come up with ₹1000 per annum. But if the deposit market isn’t very liquid, and not easily available within the marketplace for sale, then ₹10300 could be trading at a good slightly higher price as a result of demand. That means, if you sell it today, you get a financial gain (₹300), over and above the ₹1000 interest.

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

Then how are you able to gain from the falling interest rates scenario? The solution, especially for retail investors, is debt mutual funds. Bank’s Certificates of Deposits (CDs), Commercial Papers (CPs), treasury bills, government bonds (G-secs), PSU bonds, and company bonds/debentures, cash & call instruments, and so on are various fixed income instruments in which Debt mutual funds can invest. These funds are classified supported varying time frames which means you decide on a special fund for short-term needs, and a really different one for long-term requirements. Needless to mention, short-term funds tend to have low risk as you would like your money within the near term, while longer-term funds are a little riskier to get returns over the long-term.

As highlighted within the below list, risk & return increases with the tenure of investment instruments.

 Liquid & Ultra Short-Term Funds
 Short-Term Funds
 Dynamic Bond Funds
 Long-Term Income Funds
 Gilt Funds

When there is a decrement within the market’s interest rates, fixed income instruments with the longest tenure will gain more compared to the shortest tenure instruments. Hence, funds like dynamic bond funds, future income funds, and gilt funds are best placed to understand from the falling rate scenario as when rates fall, the worth of their underlying instruments increase.
Debt funds score better than Bank FDs in terms of taxation. If you hold your investments for about three years, you simply have to pay only 20 percent of capital gains tax (with indexation benefits). Since you’re taking indexation benefits (that means adjusting the price of your investment for inflation), your ‘real’ tax outgo is going to be far less than the 20 percent. But 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, supported some time frame of investment to require advantage of them.

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