One has to diversify across asset classes into art, debt, equity, gold, real estate while making any investment decisions. Investment in equity is made for wealth creation and to beat inflation over a longer time horizon. Debt investments are used for parking contingency/ emergency funds, meeting short-term goals, and meeting income needs, where capital preservation will be the main criteria and some returns. Many of us are unaware of different investment options available in debt except fixed deposits (FD). All of them are discussed below.
Debt/Income mutual funds:
Debt/income mutual funds will invest in debt securities in the market and provide opportunities for conservative retail investors' short-term objectives. There are sub categories in debt funds like gilt funds, income funds, liquid funds, ultra-short-term funds, money market funds, etc. The funds are classified based on the securities in which investments are made. Gilt funds invest in government securities only, whereas income funds invest in corporate bonds, debentures, and government securities of different durations from few months to 20+ years, which provide income in the form of dividends or interests. Liquid funds offer loans to corporate for up to 91 days, safest, lowest risk, suitable to park emergency funds, and can get higher returns than saving bank account. Ultra-short term (UST) funds and short term debt funds lend to corporates for 3-6 months duration, little risky than liquid funds but considered safer if funds are parked for 3-6 months, can provide little better returns than bank FDs of similar duration. Money market funds provide loans to companies for a short term up to 1 year. They offer higher returns and lower risk, with less capital loss, and give better returns and tax-efficient than bank FDs. Liquid and UST funds have low return volatility, and the risk of capital loss is negligible.
Debt funds and interest rate relationship:
The interest rate and market rate of debt security are inversely related. If the interest rate moves up, bond prices will move down and vice-versa. E.g., if the current interest rate is 9% interest rate of the economy rises to 10% demand for the bond 9% coupon will go down, and its price reduces as new bonds with interest rate has come to 10% from 9%. There will be an opposite scenario if the interest rate reduces in the market and the debt/income fund will deliver excellent returns.
After the collapse of the Lehman Brothers and Sub Prime issue during 2008-09, in the USA, in India, in 2008 July to 2009 April, RBI had reduced Repo-rate gradually from 9% to 4.75%. During the same period, income funds have delivered double-digit returns.
Debt/Income funds are tax-efficient than Bank FDs: Debt/ Income Fund are more tax-efficient than Bank FDs. Any gains obtained from debt/income funds are treated as capital gains, whereas bank FDs are clubbed with the assessee’s total income. If investment in debt, income funds are held for less than 3 years will be considered short-term capital gain (STCG). It will be taxed at the investor's slab rate of tax. If the investment is held for 3 or more than 3 years, it will be treated as a long-term capital gain (LTCG) taxed at 10% without indexation or at 20% with indexation. If a person is in the highest tax bracket of 30%, debt/ income funds will provide tax-efficient returns than bank FDs. The details are summarized in the below table.
| Feature | Income/Debt Funds | Bank FD |
|---|---|---|
| Nature of Tax | Capital Gain Tax | Clubbed with total income |
| Indexation Benefit | Yes | No |
| Rate of Tax | 10% without indexation 20% with indexation |
As per assesses tax slab |
| Reinvestment Risk | No | Yes |
| Capital Risk | Low to Medium | Relatively lower with quality banks |
Investment return calculation for debt/income fund and bank FD is shown with illustration in the table below:
| Details | Debt/ income funds | Bank FD |
|---|---|---|
| Principal Rs | 100,000 | 100,000 |
| Rate of return | 10% | 10.00% |
| Duration in years | 3 | 3 |
| Gains | 33,100 | 33,100 |
| Pretax value Rs | 1,33,100 | 1,33,100 |
| Tax Rate• | 10% | 30%^ |
| Tax amount Rs | 3,310 | 9,930 |
| Post tax value Rs | 1,29,790 | 1,23,170 |
| Post tax return | 9% | 7% |
• Tax rate considered without surcharge and cess.
^ For Bank FD, the tax rate is assumed at the highest tax slab.
# The rate mentioned for assumption in the illustration is not the return rate from debt/ income funds.
From the table above, one can understand that debt/income funds will be more tax-efficient and generate higher tax-adjusted returns than bank FDs. Also, mutual fund investments in debt funds will provide more yield in favorable market conditions due to the inverse relationship between bond prices and interest rates. Investors can opt for funds that generate a return through interest accruals and not by a call on interest rate movement to avoid interest rate risk.
Diversification and asset allocation are the critical factors for the successful management of investments. Investors with short to medium-term outlooks can opt for debt/income funds, as explained above.