Why debt funds may still score over bank FDs and bonds despite tax parity

Experts feel debt MFs will be more relevant in a falling interest scenario and work well for those who aren't sure about their investment horizon

Investors who held debt mutual funds for more than three years were until now taxed at 20 per cent with indexation benefit. From April 1, their capital gains will be taxed at the slab rate. While this is a major blow to investors in this space, experts say debt funds will continue to be relevant in many scenarios.

“Now debt mutual funds, bank fixed deposits (FDs) and bonds have all been brought on a par in terms of taxation. Investors will henceforth compare these products on merit and choose the one they find most suitable at a given point,” says Joydeep Sen, corporate trainer (debt markets) and author.

Declining interest rates

Many experts believe rate cuts could begin within the next 12 months. “When interest rates are falling, longer-duration debt funds could give double-digit returns, far exceeding the returns from bank FDs,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund. He concedes that when liquidity is tight, FDs may offer better returns and hence suggests allocating to both.    

Investors can earn attractive returns from debt funds by investing for the long term. “The Crisil Composite Bond Index has given a return of 8.75 per cent over the past 10 years. Debt funds have delivered returns across interest rate cycles,” says Bagla.

Shorter-duration funds—liquid, ultrashort, low-duration, and money market—were always held by investors for less than three years. The change in tax rules won’t affect them.

Defer taxation

Interest earned from bank FDs gets taxed each year at slab rate. “In debt funds you incur tax liability at redemption. You can control when you redeem and you can withdraw only as much as you need to manage your tax liability better,” says Deepesh Raghaw, Sebi-registered investment advisor (RIA) and founder, PersonalFinancePlan.

Deferred taxation in debt mutual funds, adds Raghaw, also results in better compounding of your money.

If you aren’t sure about horizon

Debt funds are better suited for investors who are not sure about their investment horizon. Suppose that you could need your money over the next six to eighteen months. You open a 12-month FD because of its attractive rate. However, your need arises after four months. Now, instead of paying the interest rate of a 12-month deposit, your bank will pay the rate of a four-month deposit and will also impose a penalty. “Open-end debt funds don’t charge any such penalty,” says Raghaw.

Returns from debt funds will be considered as short-term capital gains, which can be offset using short-term capital losses. This is not possible in FDs.

If you have invested Rs 2 lakh in an FD but need to withdraw only Rs 50,000 you will have to break the entire FD. “In debt funds, you can withdraw the amount you need without it affecting the rest of your investment,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

Arbitrage funds have become attractive. “These funds are less volatile except under extreme market conditions and get the tax treatment of equity funds,” says Luthria. Their returns could fall if too much money floods the category.