Debt Mutual Funds vs FDs: How tax benefits give debt funds an edge to beat inflation

With fixed maturity instruments in its portfolio, the return on a debt fund may also be quite stable and predictable.

Fixed Deposits (FDs) are the most popular investment instrument in India. This is because traditional investors find it convenient to park their excess money lying in bank accounts in FDs as they trust banks. Moreover, many investors are yet not familiar with the concept of mutual funds.

However, the debt category of MFs provide a wider choice for parking short-term money and may be used as an alternative investment option for bank FDs.

Risks

Debt funds are considered as capital assets. There are capital risks associated with such funds. Also, such funds are not as volatile as equity funds, as the portfolios of debt funds don’t contain equities, but contain debt instruments with predefined maturity period and return on maturity or predefined regular interest/dividend income.

So, theoretically, debt funds have higher risks compared to bank FDs as the rate of interest remains fixed for FDs for the entire investment period. As a result, FDs have a fixed maturity value.

Return

While the return on a bank FD is fixed and there is a fixed maturity amount, with fixed maturity instruments in its portfolio, the return on a debt fund may also be quite stable and predictable.

However, as the debt instruments present in the portfolio of a debt fund may be traded at secondary markets, the Net Asset Value (NAV) of such a fund may fluctuate giving higher or lower return than the returns generated by the fixed-return instruments present in the portfolio.

Effect of Inflation

As key policy rates are used to control inflation by the policymakers, Repo rate, Reverse Repo rate and the resultant overall interest rates on deposit and lending should vary with the rate of inflation.

So, the interest rate offered on FDs and the annual return or CAGR on debt fund should be close to the rate of inflation.

Why is Liquid Fund no longer a preferred alternative to FDs?

However, in case the rate of inflation exceeds the interest rate regime, the money invested in FDs would loose its purchasing power, i.e. the real return on FD will turn negative. So, FDs are considered as inflation inefficient instruments.

On the other hand debt funds may somewhat absorb the effect of rise in inflation rate, as the fixed-return instruments may be traded in secondary markets.

Moreover, indexation benefit is available while calculating long-term capital gain (LTCG) on debt funds, which makes such funds inflation efficient.

Taxation

Interest on FDs are taxable. Senior citizen investors are, however, get deduction on interest up to Rs 50,000 in a financial year.

As the interest on FDs are charged without adjusting the affect of inflation, it makes the real return on FDs even worse.

As debt funds are treated as capital assets, capital gain tax is applicable on such funds.

If units of a debt fund are sold before completion of 3 years from the date of investment, the gain/loss is treated as short-term capital gain/loss.

Such gain/loss is adjusted against total income of an investor, and hence the tax effect on short-term term gains will be same as that of interest on FDs. Moreover, senior citizens will get no deduction on short-term gains.

However, in case units of a debt fund are sold after 3 years from the date of investment, the benefit of indexation will be available. As a result the amount invested will first be adjusted against the rate of inflation during the investment period by applying the inflation index of the year of investment and that of the year of sale/redemption to arrive at the value of investment on the year of sale/redemption.

The inflation adjusted value of investment will then be deducted from the sale/redemption amount to calculate the amount of long-term capital gain/loss. In case there is some gains, the investor has to pay 20 per cent capital gain tax on it.

As the indexation benefit takes care of the effect of inflation, the amount of tax payable becomes significantly lower than the comparable gain on FDs.

So, for an investment period of over 3 years, compared to FDs, higher tax benefits provide debt funds an edge to beat inflation.