However, softening of the interest rate by the RBI leads to a fall in the prevailing fixed deposit (FD) rates, i.e., banks may also reduce the interest rates on FDs.
Though fixed deposits are considered safe investment options, one needs to look at the marginal rate of tax since investments in fixed deposits are suitable for people in the lower tax bracket. Post-tax returns on FDs are not very attractive for those in the higher tax bracket.
Debt mutual funds & interest rate
Right now, we are in a falling interest rate scenario. The RBI started reducing interest rates from April 2012. Interest rates are cyclical and they cant remain stagnant for a long time, especially in an economy like India, which is growing at a fast rate. Falling interest rates provide investors not only an opportunity to lock in money at high yields, but also offers capital gains from the rally in bond prices.
How it works
The prevailing interest rates in the economy have a direct impact on financial markets. In various phases of the interest rate cycle, different categories of mutual funds outperform the market. In a falling interest rate scenario, debt-oriented funds, mostly with a higher average maturity, do well. This is because debt funds invest in fixed-income securities issued by the government, banks and corporate bodies and these securities have a specified coupon rate.
When the interest rate falls, the value of outstanding bonds rises because the income (coupon) they pay is more than what investors could receive on new bonds. Thus, the yield on bond increases and, so, the net asset value (NAV) of debt fund increases.
Debt MF options
Gilt funds get impacted due to the interest rate cycle. Gilt funds invest in government securities that have average maturity between 1,000 and 3,000 days. Funds with high average maturity have higher sensitivity to interest rate changes. Income funds also get some heat due to any change in the interest rate scenario as they invest in fixed-income instruments issued by the government, banks and corporate bodies. Income funds maintain an average maturity of 700 to 2,300 days.
Liquid & ultra-short-term funds are the categories that are mostly used for parking surplus cash by corporate bodies. Though the average maturity maintained by these funds is around 70-150 days, they give better returns due to capital appreciation of bond prices in the short term. Investors can look at options like fixed maturity plans (FMPs) offered by mutual funds. FMPs also invest in G-Sec and debentures issued by corporate bodies, which get impacted by interest rate changes.
Investment decisions should be driven not only by the expected return, but also the needs. The needs can be anything like liquidity, monthly income, safety of capital, etc. Debt mutual funds are tax-efficient and also offer liquidity. In the current interest rate scenario, debt funds may offer higher yield compared to fixed deposits. However, inventors who have a bit of a risk appetite can look at debentures issued by private and public limited companies.
Tax on debt MFs
Debt mutual funds are tax-efficient. The long-term capital gains tax is 10% if the holding period is more than a year. They also offer the benefit of indexation, which adjusts for inflation during the holding period. The tax rate would be 10% with indexation. Short-term capital gains on debt mutual funds are added to the income. Investors should take the debt fund route. These are not only tax-efficient, but also provide high liquidity.
In a falling interest rate scenario, investors can look at income or gilt funds since falling interest rates would offer higher returns. Change in interest will be higher on the funds where the average maturity is higher. Investors can also look at dynamic bond funds. Liquid funds can be an option for investors who want to park money for a short period.
The writer is CEO and founder of Right Horizons