Managing better returns in a falling interest regime
Bank Fixed Deposits (FDs) used to be an all-weather savings instrument for most investors. They guaranteed assured returns. But, FDs have somewhat lost their sheen in the past one year or so. Interest rates on FDs have been heading south and are no longer as attractive as they were a year back.
Almost all banks have reduced interest rates on FDs between 100 and 125 basis points in the past one year. For example, a one-year fixed term FD with the State Bank of India a year back, would have earned an interest of 8.5%. If you open the same FD now, the interest rate would be 7.25%.
In such a falling interest regime, judicious investment is the need of the hour. An investor needs to balance quality with high yields on his portfolio. Broaden your perspective and look at other investment instruments like mutual funds. You must ensure that your investments guarantee a steady return. The idea is to maintain a healthy asset mix without being too adventurous. Although FDs provide safety of capital, they are not long-term wealth creators. At the same time, it would be unwise to be dismissive of FDs as everything about them is bad. Giving up the tried and tested bank FDs is not a great idea. There are upsides to FDs too. Investors can take heart from the fact that interest rates are not likely to go down much going forward. Bank deposits have generally remained low. A healthy mix of sound, long-term FDs and mutual funds in the portfolio helps beat inflation.
Looking beyond FDs
Debt funds have become popular of late. They provide an alternative to risk-averse investors helping them diversify their portfolio. Earlier this month, the Reserve Bank of India had cut the key lending rate (repo) by 25 basis points to 6.25%. This is a trigger for the banks to cut deposit rates further. But, those who had invested in debt mutual funds are likely to see their Net Asset Value rise. This is why debt funds are gaining so much in popularity.
What are debt mutual funds and why you should love them?
Debt mutual funds invest in a mix of debt or fixed income securities. These include, treasury Bills, government securities, and corporate bonds. Money Market instruments and other debt securities of different time horizons are also present. The returns are market linked and managed in a professional way. For individuals who only rely on interest income, it gets tough when interest rates fall. In such cases, debt investors willing to take a higher risk can opt for debt mutual funds. These earn returns which could be higher than FD rates,
Choosing your fund
There are three kinds of debt mutual funds, going by tenor. These are liquid funds, short-term income funds and Long-term income funds. Liquid and short-term funds have a tenor below one year. Medium means one to three years. Long-term income funds are for over three years. Investors can take their pick depending on their requirements. For example, if your time-frame is short (say three months), it is ideal to opt for liquid funds.
Income funds are a class of debt mutual funds. They invest in a combination of various financial products. These include government securities, certificates of deposits, corporate bonds, and money market instruments. Expert fund managers manage them. They track interest rate movements and keep the portfolio credit worthy. Income funds have a track record of beating three-year deposit rates. This has added to their popularity. This is a time when interest rates on bank FDs and small saving schemes are falling. Now, investors can look at debt mutual funds, particularly fixed maturity plans (FMPs). These offer better rates than FDs. These are tax efficient too, because of the indexation benefit.
Short-term debt funds provide an average return of 8.2%. This is according to the funds category returns data at Value Research. Long-term debt funds provide an average return of 7.7%. Liquid funds give a return of 7.9%.
The returns from short-term funds are like the interest earned on FDs. But, if you can hold your investments for more than three years, you get better taxation benefits. You get better return on your investment too. In a debt fund, long-term capital gains are subject to 20% tax after indexation. Short-term capital gains get added to your income and taxed at the normal rate applicable to you.
The tax rate for debt funds is 20%. This is further reduced by the indexation benefit.