As we settle into a low interest rate environment, we may be better-off deliberating beyond fixed deposits (FDs) as an investment destination. Debt mutual funds are certainly worth considering as an alternative investment option in this interest rate scenario, which have the potential to generate superior tax adjusted returns.
Falling interest rates
Interest rates over past two years have been declining with bank fixed deposit rates having fallen around 2 percentage points and counting. This has translated into lower interest income on fixed deposits for many individuals, particularly making the situation difficult for people who are dependent on interest income.
The interest rate environment in the economy may remain soft, as banks are flush with funds post demonetisation. This indicates further reduction in bank lending rates, a scenario that is always preceded by a reduction in fixed deposit interest rates. In addition, owing to benign inflation outlook, comfortable liquidity position, and lack of credit offtake in the banking system, fixed deposit interest rates are expected to remain soft. This is the opportune time to explore some smart investment options such as debt mutual funds.
Taxation benefits in debt MF
Debt mutual fund scores over fixed deposits, when it comes to assessing tax obligation. In the Income Tax Act, the interest earned from fixed deposits is added to an individual’s income, and taxed according to one’s tax slabs.
However, tax on debt mutual funds is calculated on the basis of short-term and long-term capital gains. The tax treatment on investments between one and three years is similar to that of fixed deposits. But, for investments over three years, a tax rate of 20% is applied with indexation benefits, which makes final tax obligation much lesser; while dividend income from debt mutual funds remain non-taxable.
Debt funds have a Dividend Distribution Tax but it is not applicable in the hands of the recepients.
No penalty on premature withdrawal
Most fixed deposit schemes don’t allow premature withdrawal. Let’s take an interesting example, an individual has invested `10 lakh in a fixed deposit scheme for five years that does not allow premature withdrawal. However, due to urgent requirement of funds the individual needs to withdraw `5 lakh from his fixed deposit scheme.
The person won’t be allowed to make a partial withdrawal from the fixed deposit scheme. In addition, the individual has to pay a penalty. However, in most debt mutual funds there’s no lock-in period as such. The investor has the option to redeem partial or full amount of his investments, subject to the exit load, if any, in the concerned scheme.
Recently, Reserve Bank of India reduced the policy rates to its lowest level since November 2010. The repo rate was reduced by 25 basis points to 6%. The central bank’s move is in response to moderating inflation as compared to the earlier estimates as well as the need to ensure that growth is adequately supported, given the weakness in investments.
This further indicates that the central bank may become more accommodative on future course of rates, if the CPI trajectory remains supportive and the growth outlook were to materially worsen. Hence, this is the appropriate time to explore debt mutual funds that provide potential for capital appreciation as well a relatively higher yield as compared to traditional fixed income investment avenues in a declining interest rate scenario.
The author is head, Fixed Income, SBI Mutual Fund
Source – http://www.financialexpress.com