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Debt Funds Save You Tax
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They offer better liquidity, higher returns than bank fixed deposits for low-risk investors
In the investment space, the general rule is that those who have appetite for risk should consider putting their money in equities while those who are moderate risk-takers should stick to debt instruments. While fixed income instruments such as bank and corporate fixed deposits, PPFs, post office and small savings instruments are popular, one can also invest in debt mutual funds for better returns.
Debt funds have a few advantages over bank and corporate FDs, which include a diversified portfolio comprising debt instruments, better returns, quality investment strategy, liquidity and better tax efficiency
Debt funds are classified by maturity, portfolio composition and investment strategy. These include liquid funds, money market funds, ultra short-term funds, short-term funds, income funds, gilt funds, fixed maturity plans (FMPs), dynamic bond funds and monthly income plans (MIPs).
One of the main advantages of debt funds over fixed deposits is that debt funds allow you to defer the tax liability till you withdraw investment.
If you hold debt funds for three years, you also get the benefit of lower tax compared to bank FDs. The income from debt funds is treated as long-term capital gains after three years and taxed at 20% after indexation. Indexation takes into account the inflation during the holding period and accordingly adjusts the buying price to reduce the tax liability of the investor.
An investor in the 30% tax bracket would have to pay Rs 9,116 in tax on a three year fixed deposit of Rs 1 lakh at 9% annual rate of interest. But if he invests in a debt mutual fund, he can get away by paying a tax of only Rs 172. It would save you a lot of tax if you replace the fixed deposits in your portfolios with debt mutual funds. Investors should consider a host of important parameters while choosing a debt fund. These are average maturity of the fund, duration, yield, credit rating and taxation. As the term suggests, average maturity of the fund is a measure of the average of the time periods of all the securities held in the portfolio till they mature while duration is the measure of the price sensitivity of the fund portfolio to a change in interest rates. Funds with a longer duration would be more sensitive to a change in interest rates. For example, if the modified duration of the fund is seven years and the interest rates are expected to go down (or up) by 1%, the net asset value (NAV) of the fund is likely to go up (or down) by 7%.
The yield is a measure of the interest income generated by the bonds in the fund portfolio. For example, a bond having face value of Rs 100 and coupon rate of 6% is currently trading in market at Rs 110.Then the yield that would be earned if the bond is held till maturity is 5%. In a stable interest rate scenario, this can be considered as an approximate measure of the returns that the fund can generate. While, in a falling interest rate scenario, this is not likely to be the true measure to know the fund returns, because it does not take into consideration the trading gains.
Another important factor to consider while choosing a debt fund is the credit rating of the bonds in the fund's portfolio. A credit rating indicates the credit worthiness of the borrower. Rating houses like Crisil, ICRA etc give rating to the securities in the portfolio. Credit profiles of the debt fund portfolio point toward the level of credit risk that the debt fund has assumed.
Taxation is another factor that can have major implications on debt fund returns. Long-term capital gains in debt mutual funds scheme will be derived only if the investments are held for more than 36 months. The long-term capital gains tax is 20% with indexation benefit while short term capital gains from debt funds are at tax slab rates of the individual.
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