The preferred investment option for spare cash in India is Fixed Deposits (or Recurring Deposits, which is basically a SIP version of a FD). Putting money in a FD has many advantages – the ease and convenience of investing (FDs can be opened online too), the money earns higher interest than what savings accounts offer, a high level of liquidity is assured since the money can be reclaimed anytime at short notice. and safety of the money is practically assured given the strictness with which the RBI monitors banks.
However, while it may be convenient and safe to invest your spare money in FDs, they may not give you the best returns on your investment after tax deduction. In this blog post, I look at another class of investment options – debt funds – which provide more or less the same advantages of an FD with the added benefit of a higher post-tax return on investment due to the different tax treatment for such schemes.
To put it simply, while FDs may offer higher absolute interest rates than debt funds, the interest earned is added to your taxable income for the purpose of taxation. This means that a person in the highest tax bracket will end up paying 30% tax on the interest earned, which brings the effective (post-tax) returns below that offered by debt funds.
A debt fund (also called a bond fund) is a mutual fund that invests in bonds or securities, as opposed to an equity mutual fund that invests in equities or shares. However, unlike shares (and therefore, equity mutual funds) whose prices can go up or down – meaning your investment can make losses – bonds (and hence debt funds) can only offer positive returns, with the lowest return rate being zero percent – meaning your money invested is safe even though the exact interest rate can vary based on market conditions. This makes debt funds a good alternative to FDs.
There are different classes of debt funds, each offering their own distinct features and advantages. Depending on factors like your investment horizon (how long you wish to invest the money for), liquidity requirements (how likely is it that you will need the money at short notice) and the tax bracket you fall in (10, 20 or 30%), you can choose which class of debt funds to invest in.
To summarise, the following are some classes of debt funds (there are others too):
- Liquid funds
- Ultra short-term debt funds
- Short-term debt funds
- Fixed Maturity Plans (FMPs)
These are purely alternatives to savings accounts for parking spare cash which can be needed anytime in the next few days or weeks. For example, say you need to pay Rs. 50,000 towards your son’s school fees next month and another Rs. 30,000 towards your life insurance premium two weeks after that, and this money is currently lying in your bank account. You can invest it in FDs but you will not get high returns since you will withdraw the money in 4-6 weeks. You can’t invest it in the stock market because it’s too risky. For such situations, you can invest the money in a liquid fund instead of a FD, the advantages being:
- You earn a slightly higher interest rate as compared to what the FD offers for the given duration
- You don’t suffer any additional tax liability because even the interest earned from the FD/bank account would have been taxed at the same rate.
- You still enjoy a high degree of liquidity. Redemption requests are fulfilled the next day, which means you can have your money back at a day’s notice.
These categories of debt funds come in two varieties – growth and dividend. In the growth option, the money remains invested and the NAV of the fund goes up over time. In the dividend option, the NAV of the fund is contained within a price band. As soon as the NAV reaches the top of the band, a dividend is declared and the NAV comes down to the lower end of the band. This is repeated indefinitely. Some debt funds also announce dividends at fixed intervals (such as daily, weekly, monthly or quarterly) rather than waiting for the NAV to cross a particular limit.
Liquid funds are ideal for those investing spare cash with a maximum investment horizon of 3-6 months. Depending on your tax bracket, you can choose between the dividend and growth options. People in the 10% or 20% tax bracket can opt for the growth option while those in the 30% bracket can opt for the dividend option.
Ultra Short-term and Short-term Debt Funds
These funds offer slightly higher returns than liquid funds, but the higher returns are offset by the slight loss of liquidity. Compared to liquid funds which can be redeemed at a day’s notice, ultra short-term and short-term debt funds take 2-3 days to deposit the money to your account from the time of placing the redemption request. These funds also charge a small exit load if the money is redeemed before a specified time period which varies from scheme to scheme. Such exit loads are not levied on liquid funds.
For these reasons, such funds are ideal if you need to park some spare money for a minimum duration of 3 months and a maximum duration of upto 6 months and 12 months respectively.
Depending on your investment horizon and your tax bracket, you can choose between ultra short-term and short-term bonds, and also between the dividend and growth options.
Fixed Maturity Plans
FMPs are closed-ended debt funds which typically provide slightly higher returns than open-ended debt funds of corresponding duration but offer zero liquidity, meaning money invested in these funds cannot be liquidated or redeemed midway for any reason.
These funds are ideal if your investment horizon exceeds one year and you are confident that you will not need the money before the end of the policy duration. For an investment duration of less than one year, ultra short-term or short-term debt funds can be considered instead.
The following table provides a comparison between the various debt instruments discussed above.
|Criteria||Savings Bank Account||Fixed / Recurring Deposit||Liquid Fund (Growth)||Liquid Fund (Dividend)||Debt Fund (Growth)||Debt Fund (Dividend)||Fixed Maturity Plan|
|Minimum investment duration||–||7 days||1 day||1 day||3-6 months||3-6 months||1 month|
|Maximum investment duration||–||Up to 10 years||3 months||3 months||6-12 months||6-12 months||Up to 3 years|
|Returns||Fixed (4-7%)||Fixed (known in advance)||Exact returns not known, but past performance an indicator||Exact returns not known, but past performance an indicator||Exact returns not known, but past performance an indicator||Exact returns not known, but past performance an indicator||Exact returns not known, but past performance an indicator|
|Liquidity||Immediate (via bearer cheque or ATM/Debit card)||One day from redemption request||One day from redemption request||One day from redemption request||Three days from redemption request||Three days from redemption request||Not liquid. Cannot be prematurely withdrawn|
|Tax treatment of income earned||Taxed as per your tax bracket (10, 20 or 30%) if interest exceeds Rs. 10,000 in a year||Taxed as per your tax bracket (10, 20 or 30%)||Taxed as per your tax bracket (10, 20 or 30%) if redeemed within 1 year, or at 10% with indexation or 20% without indexation if redeemed after 1 year||Dividend taxed at 27.04%||Taxed as per your tax bracket (10, 20 or 30%) if redeemed within 1 year, or at 10% with indexation or 20% without indexation if redeemed after 1 year||Dividend taxed at 13.52%||Taxed as per your tax bracket (10, 20 or 30%) if scheme duration less than 1 year, or at 10% with indexation or 20% without indexation if scheme duration over 1 year|