Since inflation has been coming down over the past six months, RBI has recently exhorted to cut their repo rate. Having got the first rate cut after a long time, we are now expecting for a series of such cuts which may lead interest rate would be headed down and debt schemes of mutual fund would do well. Though repo rate affects the interest rates and bond prices, the value of your fixed deposits which is not market-linked, should not budge at all, some banks have even cut interest rates on fixed deposits. Indeed, it is undoubtedly once again debt mutual fund schemes will actively participate and will perform well as a better alternative to bank fixed deposits (FDs) in future on the RBI has begun a rate cut cycle. However, we have pointed out several times that debt schemes are market-linked instruments, like equity mutual fund schemes, and the returns from these schemes can vary considerably depending on when you buy and sell. Therefore, before plunge into these schemes, every retail investor should know about the pro and cons while investing into them.
Debt Schemes versus Bank FDs
First of all, bank FDs and debt schemes are as different from each other as chalk is from cheese. Bank FDs offer a secure income and protection of principal but are taxable. As interest rates decline, the rates of FDs are falling. On the other hand, debt schemes are market-linked and carry interest rate risk; hence their returns could be varied over the periods. As we said, interest rate and bond prices are inversely related. Hence, bond prices go down when interest rates go up. A debt scheme invests in bonds of government and corporate issuers. Each of these bonds has a coupon rate which indicates the amount of interest on the face value of the bond. Until now, debt schemes offered a big tax benefit; but after this year’s Budget, the tax treatment of income from debt schemes, for a holding period less than three years, would be the same as that on bank FDs. However you can still take advantage of indexation benefit on the gain of debt mutual funds schemes, if you stay invested beyond three years.
How to choose a debt Scheme?
Ideally, a retail investor should invest in top performing schemes and have some understanding of interest cycles. If interest rates are headed down, debt schemes would do very well. For those looking for safety, debt schemes may be safe for the long term, but not as safe as FDs. And sometimes, their returns could be really low or even negative. Therefore, like equity schemes, it is important to take a look at the portfolio of the debt scheme to get a sense of the risk and quality of the investments. For the average investor, whose investment horizon may exceed three years, short-term open-ended debt schemes may be the best bet, thanks to the indexation benefit. They can invest regularly via a systematic investment plan (SIP); they can also withdraw whenever they need to, without being subject to a lock-in period. Exit-loads are usually charged for investments for less than a year.
A little known aspect of debt funds is that withdrawals of all the gains of a year are not fully treated as capital gains. This means that even though short-term capital gains are fully taxed from now on, the full withdrawal will not be taxed, only the capital gains component of the withdrawal, unlike interest on bank fixed deposits where the full withdrawal of interest income is fully taxed. For taking the best advantage of low tax, investors should look for an investment horizon of three years or more in debt schemes, to avail the tax benefit. After the tax changes in the Union Budget 2014, capital gains from bond schemes are taxed at 20% if held for three years with indexation benefit. Effectively, tax on capital gains will be very low. Hence, it can be said that debt funds are more tax efficient than bank fixed deposits.
When should Invest?
We have held that investing in debt schemes is not easy for the average saver. One needs to track interest rate movements. Just like in equities, where timing is crucial, in debt schemes too, one needs to time the buying and selling, to get optimal returns. Apart from timing, one needs to choose the right scheme. Nearly 150 debt schemes are available. The performance of the schemes can vary drastically. However, it would be an opportune time to invest in bond schemes when yields are above 8.50%. If you had invested in a top scheme last year when bond yields were hovering above 8.50%, your investment would have yielded far better returns than a bank fixed deposit. So if interest rates are expected to go down, long-term debt schemes would be the ideal choice. However, while you may be able to time your buying, you would need to time your selling as well. If you need to sell your investments in a period of rising interest rates, you would end up with poor returns. Hence, for the average saver, short-term debt schemes would be an ideal choice. Finally, long-term schemes would be expected to deliver a higher return if interest rates decline.
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