The Mutual Fund Show: Corporate Fixed Deposits Versus Debt Funds — Here's What To Consider
Debt funds can be an efficient way to invest in terms of tax outgo and returns.
Rising interest rates may tempt investors to park their funds in corporate fixed deposits on the promise of better returns than debt mutual funds.
That is not the correct investment strategy, according to Vijai Mantri, chief investment strategist at JRL Money. "Even if you look at the last couple of years, debt mutual funds remained extremely competitive."
Debt mutual funds can be the efficient way to invest in terms of tax outgo as well as overall returns, Mantri said in conversation with BQ Prime's Niraj Shah on The Mutual Fund Show.
"Even if you compound in bank FD or your corporate FD, there is a TDS (tax deducted at source), there is annual tax outgo. So, to that extent, your compounding doesn't happen that effectively," he said. "In a debt mutual fund till you take money out ... there's no taxation at all."
Assuming that the inflation print for the next year comes to be 6%, and if an investor's Rs 1 lakh in a debt fund becomes Rs 1,21,000 at the end of three years, Rs 1,13,500 will be the cost, according to Mantri. The difference between the two numbers will be capital gains, on which an investor pays 20% tax, Mantri said.
Data from the last 20 years show that the average taxation rate for debt mutual funds has been lower than equity mutual funds, he said, making "a far more tax efficient way to look at investing."
For an investment in a bank FD for a tenor of next 30 to 45 days, the returns could be around 4%, but a comparable liquid fund can generate over 7%, Mantri said.
"Similarly, you could look at six-month, nine-month, 12-month periods, where the bank FD rate is 4.5%, maybe 5%, and look at ultra short-term bond funds or money market funds where YTM is 7.5%," he said. "One year, two-year, three-year ... bank FD rates could be anything between 6 and 7%, or corporate FD rate which could be 7.5%."
"...keep one thing in mind, in the bank FD, the bank decides the rate of interest; in the debt mutual fund, the market decides the rate of interest."
Watch the full interview here:
Edited Excerpts From The Interview:
Should people look at mutual funds at all? In fixed deposits the returns are pretty good.
Vijai Mantri: Yes, I think people should examine it because what happens is that whenever people compare debt investing, they look at current FD rate and then compare the last one-two-three-year return of debt mutual fund.
In the rising interest rate scenario, last one to three-year return of debt mutual fund will not look good but the current FD rate would look good. So, investor will make a mistake saying that last couple of years return has not been good in debt mutual fund, current FD rate does look very good, so, let me go and put that money into bank FD.
That perhaps is not the right way to look at it because the current FD rate is the return you are going to get in future. Similarly, what we should be looking at was what the FD rate was one year, two years, even three years back and how the debt mutual fund has done. Even if you look at the last couple of years, debt mutual fund remained extremely competitive.
So, the right thing to look at is very simple, what is the time horizon for which you are looking at investing? One year, three years, five years whatever time period you look at, look at the bank FD rate or corporate FD rate available in the market right now and look at the comparison of similar maturity debt fund. So, for instance, 7 to 45 days or 90 days bank FD is around 4%. The competitive product is liquid fund where YTM is 7.2%.
What does it mean? Suppose you invest today for the next 30 to 45 days in bank FD, we are going to get perhaps close to 4% but in liquid fund you're going to get 7% plus kind of investment performance. Similarly, you could look at six month, nine month, 12-month period where the bank FD rate is 4.5%, maybe 5% and look at ultra short-term bond fund or money market fund where YTM is 7.5%.
It means that over the next six-nine to 12 months and that is the kind of investment performance you are going to get and you could look at one year, two year, three years where the bank FD rate could be anything between 6-7% or corporate FD rate which could be 7.5%.
But look at the competitive product available in the market. Low duration for one year product, YTM for it a floater, and low duration YTM is 775 to 780. If we look at credit fund, if we look at medium-term fund, if we look at the corporate bond fund, YTMs vary from 8% to 8.6%. So that is the kind of return you're going to get in future so when investing in debt mutual fund.
There is no point looking at the last one-two-three years return because that is not what you are going to get in future. What you are going to get in future is, what is the YTM of a debt mutual fund and currently debt mutual fund YTMs are far superior because just keep one thing in mind, in the bank FD, the bank decides the rate of interest, in the debt mutual fund market decides the rate of interest.
So, for instance, if you look at a bank one-year FD, it could be 5.5% or 6.5%. But the same bank corporate deposit certificate is available at 7.75% in the market, because that is a market-linked instrument.
So, debt mutual fund, if you put money in one-year FD, you are going to get 6 to 6.5%. But if you put money in a debt mutual fund which invests in bank CD, you are going to get to 775 basis points, that one needs to keep in mind.
If you take the right tenor and the right kind of debt product then there is a marginally superior rate as well and I presume the benefits of indexation coming as the tenure of your holdings moves up slightly as well.
Vijai Mantri: That's very true because the way debt is being taxed is very, very different. Debt mutual funds are being taxed very differently. For instance, right now just focus on the topline without considering taxation, debt mutual funds are far superior because suppose your bank FD, where interest comes every three months or six months, or your corporate FD or your corporate NCD, if you are not compounded, then what happens the interest get completely wasted.
In debt mutual fund, there's no leakages of interest being not reinvested, it gets reinvested very efficiently. Even if you compound in bank FD or your corporate FD, there is a TDS, there is annual tax outgo. So, to that extent your compounding doesn't happen that effectively. In debt mutual fund till you take money out, first of all, there's no taxation at all. There's no annual tax provision you need to make, that is one thing you need to keep in mind.
Second, suppose your holding period is more than three months, then the way debt mutual fund get taxed is that your cost is increased by 75% of the inflation number. Yes, so in a three year plus, suppose let's take for very simplistic vision, next year inflation happens to be 6%.
So, we are not compounding, we are taking a simple number. So, 6% plus 6% plus 6% is 18%. Now, cost inflation index is 75% of CPI inflation. So, 6% ka 75% is 4.5 plus 4.5% plus 4.5% plus 4.5%. So, it becomes 13.5%.
I am not compounding it. So, if you are a debt mutual fund your Rs 1 lakh at the end of three years become Rs 1,21,000, then Rs 1,13,500 is your cost and the gap is only treated as a capital gain on that you pay 20% tax.
So, effectively your tax rate incidentally, in debt mutual funds, the average taxation rate of the last twenty years data suggests that it has been lower than equity mutual funds. So, it is a far more tax efficient way to look at investing and one needs to keep two things also in mind.
We pay tax, we don't have a choice as long as we are earning, besides that, we pay 20% indirect tax on all the consumption items we have. Now we keep complaining about higher tax rates and we keep complaining about higher GST on the consumption item. But as far as investment is concerned, there is a choice given by the government. I don't know why we are not utilising it effectively.
Vijai, tell us a different tax slabs, the corporate FD versus debt mutual funds, the returns that come in and the kind of returns needed to match the corporate FD and the category for the same.
Vijai Mantri: So, it's very, very interesting. Suppose you have a 7.5% corporate FD and you bought that FD and you bought this FD with compounding. So, Rs 1 lakh invested and suppose you are not paying any tax. Rs 1 lakh becomes Rs 1,43,000 at the end of 5-year corporate FD.
To match that, debt mutual fund needs to compound your money at 7.5%. Today we have many products, medium term, corporate bond, PSU bond, the YTM has been from 7.72% to 8.63%. By the way in all three categories, in the last 10 years, where the FD rate has been very low in in all these categories, the return has been for last 10 years where FD rates have been, it has been very low. So, even in the last ten years they have done very well.
Now we are talking about an elevated rate of interest going forward, I don't see why all these debt fund will not be able to beat 7.5%, suppose we take 0% taxation. But suppose you're in the 10% tax bracket, then at the end of five years, your one lakh becomes Rs 1,38,000- Rs 1,39,000. Their mutual fund, after paying tax would become Rs 1,39,000 effectively. Debt mutual fund need to deliver 7.4% effective to match the 7.5% corporate FD rate and that is low duration and medium-term fund can do very, very easily.
Suppose you are in a 20% tax bracket, then Rs 1 lakh becomes Rs 1,34,000 and mutual fund has Rs 1,39,000 to match corporate FD rate, a debt mutual fund needs to compound only at 6.48 % very ultra short-term money market YTM close to 7.5-7.75%.
If you're in a 30% tax bracket then Rs 1 lakh becomes Rs 1,29,000 at the end of five years in a debt mutual fund. For the same tax bracket person, Rs 1 lakh becomes Rs 1,39,000, effective yield on corporate FD is 4.56%, effective yield on a debt mutual fund is 7.4%.
Even liquid fund will outperform because current YTM of liquid fund is 7.2% and suppose you are in 37% tax bracket, then Rs 1 lakh actually at the end of five years becomes Rs 1,26,000. In debt mutual fund it is Rs 1,39,000, effective yield if you are in 37% tax bracket, then on 7.5% bank FDs, effective yield is below 5% which actually call, many can easily outperform, current call money is 6.2%. But if you look at the last 10-year data at all, many funds on average, they deliver 6% compounded return for a 10-year period.
So, though corporate FD gives you some comfort, bank FD gives you some comfort of predictability of the investment performance. Real data clearly shows that debt mutual fund outperforms corporate FD and bank FD by huge margin and one needs to keep it very simple.
If the banks are offering higher interest rates on FD, if the corporates are offering higher interest rates on FD, it means that they are also offering a higher interest rate on the publicly traded instrument. So, whether already issued CP, corporate-issued NCD or bank-issued NCDs, and bank-issued CDs to those products are being captured by a mutual fund and mutual market rate moves faster either way.
So, what does a bank do when interest rates are rising, they do not increase their deposit rates immediately. They do with a timeline, and they don't do full quantity, but the loan rate can reprice very, very fast, but in debt mutual fund, it captured the market rates.
So, what happens if the interest rate goes up in the economy, that debt mutual fund gets repriced very, very efficiently. So, I have looked at data for the last 20-25 years, I have no doubt in my mind that except what we have seen in 2018 and 2020, there was a little hiccup on debt mutual fund, a debt mutual fund has added significant value to the investor with or without taxation.
I thank you for giving us these details.
Vijai Mantri: One additional point which is very important, lost harvesting. Suppose you have a FD of DHFL, and you also had a FD of HDFC Ltd. and on DHFL FD you are not recovering money or not recovering your money fully, so you have some losses, but these losses will not be allowed to be adjusted against the gain you are making from HDFC FD.
So, the interest which you are gaining from HDFC FD that interest will be taxed so you can’t adjust the losses you made on DHFL FD or PMC bank FD or any private lending you do.
But in debt mutual fund, suppose one fund has some losses, you can adjust that against another fund, that is one part. The second part, which is very important, if you have a gain on debt mutual fund, be it short-term or be it long term, it can be adjusted against your short-term losses or long-term losses in any of the portfolio.
Be direct stock, be it equity mutual fund or your real estate or gold or art, whatever you have. So, loss harvesting is a very, very powerful tool, which most investors haven't experienced with debt mutual funds, so, they are not examining it, but it's a very, very powerful tool.
Now, there is this table that you have given, it speaks about the average effective debt mutual fund taxation with some holding periods given and some returns given on debt mutual funds. Please explain it to us.
Vijai Mantri: So, this table is very simple. I looked at actual data of the last 20 years. So, if your average holding period has been three years or average holding period has been five years or seven years or ten years and suppose debt mutual fund deliver you 7% return or 8% or 9% return, then what is the effective tax rate you have incurred.
So, let's put it this way, if our average holding period has been three years, and debt mutual fund delivers you 7% return, then your rate of tax has been below 3%. If a debt mutual fund delivers 8% return, then your rate of tax has been 5% and if a debt mutual fund delivers 9% return then your rate of tax has been below 7% and so on so forth.
If you invest in, for instance, your average holding period has been 10 years and you got 7% return then the effective tax rate has been pointing 7% effectively, 7% tax free, and suppose you are lucky to get 9% return compounded over a 10-year period, it means the effective tax rate has been just 6%.
Why it happens, we explained in the past, because inflation goes up. If inflation goes up CII numbers come higher, CII numbers are 75% of inflation and the cost of acquisition goes up to the extent of CII number compounded every year. It is a cost for income tax purposes. So, it is not the actual cost you are paying. So, you may have actually gained.
But for tax purposes the gain comes down because of CII number and also the gain doesn't get taxed at 30% or 37%, it gets taxed at 20%. So because of CII inflation and 20% taxation, your effective tax rate in last 20 years in India for a debt mutual fund on an average has been much lower even lower than equity mutual funds.
Vijai, any last words of advice on this topic?
Vijai Mantri: It is very important that from where the debt market return comes, debt market delivery return which are closer to inflation. So, if inflation is 6%, debt market will deliver at 5.5% to 6.5% through various instruments.
But one important thing investor needs to keep in mind is that inflation compound and most debt instrument except debt mutual fund effectively do not compound, one part.
Second part, higher coupon rate does not mean compounding at the same rate of return. People having 10% tax-free bond does not mean that they compounded their portfolio by 10%, let's keep that in mind.
And third point, if the returns are closer to inflation, CII cost is also closer to inflation. This is what history has done, in future also until the government tweaks their policy, the normal taxation would remain around what we have discussed right now.
Vijai, that is my final question and that is for people who have home loans. For somebody who's got a large home loan and is paying that about 8% rate of interest currently, it is 6.5%, 7% since the last few months or quarters, do debt mutual funds or fixed deposits or any debt product make sense?
Vijai Mantri: I don't think because on FD you may get 8%, even if it's 7.5% you need to pay tax on that. So effectively it comes down to 5% even if you don't pay tax. But on the home loan you're paying 8% plus interest. So, reduce that outgo because that outgo is after you are paying taxes.
So, it is just not that you earn and then you pay taxes and then you serve housing loan, don't fall into that trap. Suppose if your housing loan then whatever money you collect, please go and pay housing loan, if you have emergency, your equity mutual fund portfolio, you can take loan against at any point of time.
If you have an emergency, you can do take personal loan as well. You don't know when the emergency will come but housing loan, that metre runs fixed. So, if you have a housing loan, and also liquid fund, I don't think it's a great combination.
I think we should repay housing loan to the extent of your debt mutual fund portfolio or FD or have equity which will give you a much better return and as we did a programme earlier. If your equity mutual fund portfolio is delivering 12% plus returns then whatever in excess of 12% redeem that and pay your housing loan.