Fixed Deposits (FDs) are the most common investment instrument in India. This is due to the fact conventional investors discover it handy to park their excess dollars lying in bank accounts in FDs as they trust banks. Moreover, numerous investors are but not familiar with the idea of mutual funds.
However, the debt category of MFs provide a wider decision for parking brief-term dollars and could be utilized as an option investment choice for bank FDs.
Risks
Debt funds are regarded as capital assets. There are capital dangers linked with such funds. Also, such funds are not as volatile as equity funds, as the portfolios of debt funds do not include equities, but include debt instruments with predefined maturity period and return on maturity or predefined standard interest/dividend earnings.
So, theoretically, debt funds have larger dangers compared to bank FDs as the price of interest remains fixed for FDs for the whole investment period. As a outcome, FDs have a fixed maturity worth.
Return
While the return on a bank FD is fixed and there is a fixed maturity quantity, with fixed maturity instruments in its portfolio, the return on a debt fund could also be rather steady and predictable.
However, as the debt instruments present in the portfolio of a debt fund could be traded at secondary markets, the Net Asset Value (NAV) of such a fund could fluctuate providing larger or reduced return than the returns generated by the fixed-return instruments present in the portfolio.
Effect of Inflation
As essential policy prices are used to manage inflation by the policymakers, Repo price, Reverse Repo price and the resultant all round interest prices on deposit and lending really should differ with the price of inflation.
So, the interest price provided on FDs and the annual return or CAGR on debt fund really should be close to the price of inflation.
Why is Liquid Fund no longer a preferred option to FDs?
However, in case the price of inflation exceeds the interest price regime, the dollars invested in FDs would loose its acquiring energy, i.e. the genuine return on FD will turn unfavorable. So, FDs are regarded as inflation inefficient instruments.
On the other hand debt funds could somewhat absorb the impact of rise in inflation price, as the fixed-return instruments could be traded in secondary markets.
Moreover, indexation advantage is obtainable whilst calculating lengthy-term capital achieve (LTCG) on debt funds, which tends to make such funds inflation effective.
Taxation
Interest on FDs are taxable. Senior citizen investors are, nevertheless, get deduction on interest up to Rs 50,000 in a economic year.
As the interest on FDs are charged without the need of adjusting the influence of inflation, it tends to make the genuine return on FDs even worse.
As debt funds are treated as capital assets, capital achieve tax is applicable on such funds.
If units of a debt fund are sold prior to completion of 3 years from the date of investment, the achieve/loss is treated as brief-term capital achieve/loss.
Such achieve/loss is adjusted against total earnings of an investor, and therefore the tax impact on brief-term term gains will be very same as that of interest on FDs. Moreover, senior citizens will get no deduction on brief-term gains.
However, in case units of a debt fund are sold immediately after 3 years from the date of investment, the advantage of indexation will be obtainable. As a outcome the quantity invested will very first be adjusted against the price of inflation throughout the investment period by applying the inflation index of the year of investment and that of the year of sale/redemption to arrive at the worth of investment on the year of sale/redemption.
The inflation adjusted worth of investment will then be deducted from the sale/redemption quantity to calculate the quantity of lengthy-term capital achieve/loss. In case there is some gains, the investor has to spend 20 per cent capital achieve tax on it.
As the indexation advantage requires care of the impact of inflation, the quantity of tax payable becomes considerably reduced than the comparable achieve on FDs.
So, for an investment period of more than 3 years, compared to FDs, larger tax rewards provide debt funds an edge to beat inflation.