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Why Debt Funds continue to score over Bank FDs even after the Franklin event?

Some investors are connecting dots to infer that debt funds are a riskier lot and contemplating going back to the ‘safe-haven’ bank Fixed Deposits (FD). But would that be the right thing to do?

A month ago, Franklin Templeton closed six of its debt schemes induced by redemption pressure and its inability to sell low-rated bonds in the market. 

Earlier this year, exposure in the troubled Vodafone-Idea papers had led many debt funds to mark down their NAVs.

Some investors are connecting dots to infer that debt funds are a riskier lot and contemplating going back to the ‘safe-haven’ bank Fixed Deposits (FD). 

Let’s compare the two products on the following parameters:

1. Default risk

Bank FDs are considered a ‘safe haven’, since it comes with the security of compensation of up to Rs 5 lakh per deposit from Deposit Insurance and Credit Guarantee Corporation (DICGC), in case of defaults. 

Debt funds, in turn, invest their portfolio across debt papers of government and companies. Except for credit-risk funds, where the endeavour is to earn higher returns by investing in lower-rated bonds, most categories of debt funds invest largely in top-quality bonds. However, some deviate in their quest to be on top of the return charts, and ultimately, pay the price. 

Bad apples

Banks don’t have a clean chit either. Banking history is replete with failures in both the private and public sector. In the last one year itself, depositors of PMC and Yes Bank faced hardships with restrictions being imposed on fund withdrawals.  While it’s a different issue that RBI bails out many of these failed banks (by merging it with bigger ones), there is no denying the fact that bank depositors remain vulnerable to financial mismanagement of banks. 

2. Liquidity

Once you invest in a bank fixed deposit, you can withdraw only at the time of maturity. Any premature withdrawal entails a penalty of one per cent or more. In contrast, debt funds are highly liquid and could be redeemed at short notice. 

However, given the shallow market for low-rated bonds in India, there can be liquidity issues, if there are mass redemptions in a fund that invests predominantly in low-rated bonds. This is what happened with the afflicted debt funds of Franklin Templeton. Most other funds that invested in top quality bonds didn’t face any liquidity issues. 

Despite a high-interest rate on an FD, post-tax annualized return of bank FD (5.8%) was lesser than that of liquid and ultra-short funds (6.2%) over a five-year period (see chart). Overall returns of low duration funds were however relatively lower due to negative returns posted by few funds that took an unwarranted risk.

3. Tax efficiency

While debt fund returns are not fixed like that of bank FDs, they are comparable. Five years back, a popular public sector Bank's FD (perhaps amongst the most secure and popular FDs) for a tenure of five years yielded 8.25 per cent annually on a pre-tax basis. Liquid and ultra-short debt funds gave an annualised return of 6.8 per cent, on an average, in the last five years.

While debt fund performance is susceptible to interest rate changes in the economy, they are more tax-friendly as compared to a bank FD, especially if investors hold for at least three years. 

In the case of bank FDs, interest income is taxed annually at the marginal rate (31.2 per cent for the top income bracket). In contrast, capital gains for debt funds are taxed at a lower rate of 20 per cent after providing for indexation. This, in turn, makes their post-tax returns superior to that of bank fixed deposits for the one, three as well as the five-year period.  

Despite a high-interest rate on an FD, post-tax annualized return of bank FD (5.8%) was lesser than that of liquid and ultra-short funds (6.2%) over a five-year period (see chart). Overall returns of low duration funds were however relatively lower due to negative returns posted by few funds that took an unwarranted risk.

Investment strategy

For your debt requirements, a combination of investments into low-risk debt fund categories (liquid, ultra-short duration and low duration funds) should suffice. They carry lower interest rate risk due to investment in debt securities that mature within a year. 

While choosing funds, don’t chase returns and focus instead on safety aspects. For instance, by checking if their investments are in high safety instruments (Sovereign, AAA, and A1).

This, in turn, will allow you to protect your capital as well as outperform the returns of Bank FDs over a three to five-year period.

Takeaway 

An unwarranted risk taken by a few players doesn’t make debt funds a bad proposition. It stills continues to score over bank FDs on a post-tax basis. Focus on the three safe debt categories to meet your debt requirements.

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