Stay nimble, choose debt funds over FDs

These schemes give higher returns than savings bank accounts and more flexibility than fixed deposits

Equity markets are scaling new highs almost daily, on hopes that there will be a strong and stable government. However, there has been very little change at the fundamental level to support such a rally. The worry that equity markets may be overheating has lead to a substantial reallocation of assets from equities to debt instruments. Since debt instruments are not as volatile as equity, they are considered safer investments. Let us look at some of the popular debt investment options and how you can choose the appropriate one.

Keep surplus cash in liquid funds

Many of us let surplus cash lie in savings bank (SB) accounts, since they offer liquidity and safety. However, there are other options which are as liquid and at the same time provide an opportunity to earn higher returns as compared to SB accounts.

These are liquid funds offered by mutual funds. These funds invest in money market securities like treasury bills, certificates of deposit and commercial papers, having a maturity of 91 days or less. This reduces volatility and also ensures liquidity.

Most banks offer 4 per cent on SB accounts, while some offer up to 7 per cent if you keep more than Rs 1 lakh in the account. As against this, liquid funds offer 8.5-9 per cent. Some of them also offer ATM cards which facilitates withdrawal from the fund subject to certain conditions. Most liquid funds don't charge an exit fee. But they are not suitable if you want to invest for more than one year as you can earn higher returns from short-term or income funds.

Bank fixed deposits

Bank fixed deposits are one of the safest investment options. Currently banks are offering around 8-9.5 per cent on one-year FDs.

Since the capital is protected, FDs are a good option for those with extremely low risk appetites, such as senior citizens. However, FDs are not tax efficient. They are taxed as per the tax slab and this eats into the returns over the long term. During times of high inflation, this proves to be a big disadvantage.

Fixed maturity plans

These are closed-ended funds which invest in government bonds and gilts to ensure capital protection along with capital appreciation. FMPs have a maturity period of between 90 days and three years, with the one- year option being the most popular. These funds are safe since they invest only in highly rated government paper.

However, unlike FDs they do not guarantee any interest rate, and one has to take into account their past track record, investments made till date and other market factors, to estimate the interest that can be earned. FMPs can be good options in a rising interest rate cycle as they can lock in higher rates.

FMPs are more liquid than fixed deposits and come with tax benefits. FMPs are thinly traded on the stock exchanges but one can still exit through this route if necessary. It is advisable to hold on till maturity for maximum benefit, or hold for a period of a year at least, to benefit from indexation and save on tax. The biggest drawback of FMPs is the fact that no interest rate is pre-announced, and it is a 'risk' in that sense.

Taxability

Interest from SB accounts is subject to income tax if it exceeds Rs 10,000 in a year.

Incomes from both fixed deposits and FMPs are taxable. However, while FD interest is taxed at the applicable tax slab, FMPs have the advantage of indexation (which is the calculation of the returns earned after taking into account inflation rate) if held for over a year. For FMPs held for less than a year, the income is taxed at the applicable slab.

In case of liquid funds, dividend income in the hands of investor is tax free; however there is capital gains tax. Short-term capital gain is charged at the investor's tax slab whereas long-term capital gains tax is charged at 10 per cent without indexation and 20 per cent with indexation.

Similarly, in the case of long-term FMPs (over a year), the FMPs are taxed at 10 per cent without indexation and 20 per cent with indexation.

Essentially, the purchasing price of the FMP is increased to take into account inflation during the holding period, using the government's cost inflation index. This effectively reduces capital gains, and hence tax. One can choose the option (with or without indexation) that has a lower tax outgo.

A recent study by CRISIL has found that FMPs have consistently beaten FD interest over the past three years. Add to it, the tax advantage and FMPs clearly become the better debt investment option.

Debt instruments are one of the best ways to counter financial market volatility as they ensure capital protection and offer moderate returns as well. One should not try to time the market and keep churning the portfolio, but do a monthly or quarterly review and make any changes necessary periodically.

The author is CEO, Right Horizons