With interest rates trending down, investors are spoilt for choice. The options before them include fixed deposit instruments of banks, corporate deposits or longer-tenure mutual fund debt instruments. It?s a no-brainer that the longer-tenure debt instruments will generate a yield in excess of bank fixed deposits over a multi-year horizon. This is fine for investors who are long on debt funds and want a higher yield.
Yield and cash flow (in terms of dividend distribution) are two different things. A bank fixed deposit would give into the hands of the investor a fixed and certain sum of money, based on the pre-determined interest rate, irrespective of the yield, which may not be the case with dividends from mutual funds.
Case study
Let me give you this real-life case of a retired investor, Sanil Kapoor, who is an informed investor. He parks his surplus funds in liquid mutual funds and invests in accordance with the asset allocation plan. He also needs a regular income for which he has invested in bank fixed deposits. The regular income, so required, is fixed and he needs the said amount every quarter. As there is certainty in fixed deposits, he prefers that route.
Sanil has also engaged an advisor who has advised him to reconsider his bank fixed deposit investments. In a falling interest rate scenario, debt mutual fund investments will generate a yield in excess of the bank fixed deposit, in a multi-year investing horizon.
The advisor has also suggested that Sanil choose a dividend option, which would ensure that he continues to get income at regular intervals. This is a win-win situation. You get an increased yield and also dividends at quarterly intervals. Moreover, as Sanil is in the 30% tax-bracket, the net yield from the long-term debt mutual funds will be higher by 1-2% (the difference would come down, if the Budget proposal of increased dividend distribution tax comes into effect).
Let?s now understand the math with a hypothetical situation. Bank FDs generate a pre-tax return of 9.75%. Long-term mutual funds, with a dividend option, are expected to generate a yield of 10-11% over a multi-year horizon. Though the yield is higher in debt mutual fund, the money in absolute terms is more in case of bank fixed deposits. This is because the dividend, which is distributed in real terms, is lower, though the yield, which is the measure of returns for all practical purposes, is the real barometer.
So, Sanil who gets a net return of R1,700 from the fixed deposits will get get only R1,500 from a debt fund, though the yield in debt mutual funds is higher. So, what you get in hand in terms of dividend and the yield would vary. This is important for every investor to know and understand when comparing the products within the asset class.
It?s very important to understand the product and the way it works. Cash flow and yield could vary and every investor should acknowledge the fact and, then, proceed with his investments. If a lower cash flow and a higher yield works for you, invest accordingly. Else, a higher cash flow and lower yield is what you may require. There is no right way or only a single method of investing. Each of you is unique and there are enough products for investing, for each one of you.
The author is founder and managing partner of Zeus WealthWays LLP