Invest in FDs or debt funds? Read on...

The fact that the media is plastered with advertisements from banks offering 8.00 per cent per annum for a 290-day fixed deposit has attracted a lot of investor attention. At Personalfn, our team of financial planners has in recent weeks, been approached by numerous investors, who wished to invest surplus funds in FDs.

With interest rates on the ascent, fixed deposits have undeniably emerged as attractive investment avenues. Similarly, rising bond yields mean that debt funds are also rather attractively poised from a 'fresh investment' perspective. We have already seen fund houses launch a plethora of fixed maturity plans and similar structured products with a view to capitalise on this phenomenon.

Popular perception suggests that high coupon FDs are "in vogue" and should be accorded preference over other comparable avenues. But is this preference justified? Given that interest rates are on the rise, investors need to be careful while locking in their monies even for a 1-Yr period. Any subsequent uptick in interest rates would mean an opportunity loss for FD investors who have their returns locked-in at lower rates.

We decided to conduct a study by facing off FDs vis-à-vis short-term debt funds; we also took into consideration a vital aspect that is often overlooked i.e. tax implications on the returns. Our study threw up some rather interesting results.

FDs vs. Short-term debt funds

We have considered a 1-Yr investment time frame for our study. An FD from HDFC Ltd. with an "AAA" rating has been chosen for comparison. The amount invested is locked-in for the investment tenure as a premature encashment would entail loss of interest.

Similarly the yield on the 1-Yr 11.90 per cent GoI paper has been used for determining the expected return from a short-term debt fund. As on August 8, 2006 the yield was 6.90 per cent. Simply put, an investment in the given debt paper held until maturity (one year hence) will yield a return of 6.90 per cent. Furthermore, for the sake of simplicity we shall assume that the dividend option is chosen and that the entire appreciation is paid out accordingly by the mutual fund.

Effective post-tax return

Since Section 80L (which used to provide for tax-free interest income upto Rs 15,000 per annum) has been omitted, interest income from FDs is chargeable to tax. Considering the various tax brackets, the effective returns amount to 6.96 per cent, 6.17 per cent and 5.38 per cent for investors in the 10 per cent, 20 per cent and 30 per cent tax brackets (including 2 per cent education cess) respectively. Similarly for investors whose taxable income is greater than Rs 1 m (Rs 10 lakhs), where a 10 per cent surcharge is applicable, the effective return would amount to just 5.14 per cent.

Dividends on debt funds (including short-term funds) paid to individuals are subject to a dividend distribution tax charged at 14.03 per cent. Although the dividends are tax free in the investors' hands, the tax is borne by the mutual fund scheme (i.e. the scheme pays it on the investor's behalf; effectively the returns are impacted by this tax). Hence, in case of a dividend declaration of 6.90 per cent, the net payout (after deducting tax), to investors would be 5.93 per cent. Also the effective return is consistent for individual investors across tax brackets.

Clearly for investors in the highest tax bracket, investing in a market-linked avenue like a short-term debt fund could prove to be a more lucrative proposition vis-à-vis an assured return instrument like a fixed deposit.

What should investors do?
For starters, investors would do well to look beyond just the coupon rate being offered on various investment avenues. Instead they should look at the effective returns i.e. post-tax returns to determine the attractiveness or otherwise of various investment avenues.

Also, investors must prioritise their needs before making an investment decision. If a higher return is the key factor, investors in the highest tax bracket could consider investing in short-term debt funds. However it should be understood that the same entails taking on a higher degree of risk vis-à-vis an FD investment, since the returns are not assured. For investors in lower tax brackets (10 per cent and 20 per cent), the FD should be the preferred avenue.

If liquidity is what the investor seeks, short-term debt funds would score over FDs. Also the penalty clause applicable on premature encashment in FDs will contribute to reducing their attractiveness.

Conversely if the investor gives the highest degree of importance to capital preservation, then FDs should be his calling.

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