Bond Mutual Funds – Better Option than FDs

With FD interest rates falling, you can earn more by investing in bond mutual funds


Bond Mutual Funds – Why?

So, are bond mutual funds a better option than FD interest rates?

The Interest Rate (RBI benchmark rate) in India averaged 6.69 percent from 2000 until 2017. They reached an all-time high of 14.50 percent in August of 2000 with a record low of 4.25 percent in April of 2009.

So, the interest rates are coming down. State Bank of India followed by other banks have lowered the interest rate on savings bank accounts to 3.5 per cent. FD rates being offered by banks are in the range of 5.75 to 6.75 percent, and are perhaps headed lower. This is a reduction of almost 25% in earning for persons investing in FDs.

Indian savings are largely in either fixed deposits or bank savings accounts. Most analysts also believe that in about a year or so rates will fall even more. It is a possibility that most banks will be paying a meagre 3.5 percent on savings accounts and 5 to 5.5 percent on fixed deposits.

Most individuals will surely look for better investment avenues at this point. Let us look at the available alternate options.

Bond Mutual Funds

Bond mutual fund are products that fit the bill perfectly. They give you higher returns than banking products, and are also liable for less tax. This makes the effective return very attractive. The convenience is still not up to the level of a savings account, although it is quite close.

The types of mutual funds that make a good substitute for bank accounts are mutual funds that invest in the bond market. These are categorised into liquid funds, ultra-short-term funds, and short-term funds. These types of funds have predictable and stable returns that have negligible volatility. Over the last one year, liquid fund returns have been an average of 6.62 per cent, ultra-short-term fund returns have been 7.45 percent, and short-term funds 8.62 percent. These are substantially higher than traditional bank products.

The key thing to keep in mind is that as interest rates in an economy fall fixed-income depositors get increasingly worried. On the other hand, bond investors gain from rising prices of the bonds that make up the portfolios of bond funds.

In addition to the return factor, there’s much more to the credit of these funds. Firstly, liquid funds can be invested in and redeemed through a smartphone-based app for many fund companies. Through these apps, you can invest instantly by transferring money from your bank accounts. More importantly, you can redeem your investment and the money gets transferred to your savings account the very next day. In case of certain liquid funds, the redeemed amounts are made available within five to ten minutes. I have personally tried this and the convenience is magical.

More Benefits of Bond Mutual Funds

Fixed deposits can be replaced with ultra-short-term and short-term funds. The former is a good substitute for FDs of up to a year and the latter for longer periods (1-3 years). In exchange for higher returns, you do have to wait for two business days for redemption. However, the financial benefits are large.

The benefits of investing into bond funds go beyond the higher return comparison. This is currently about 6.25% vs 8.6%. There’s an even bigger difference when you consider the post-tax returns. The tax difference is because fixed deposit returns are classified as interest income while mutual fund returns are classified as capital gains. Under interest income, you must pay tax every year for the what you earned in that year. If your total interest income from a bank (all accounts and deposits together) exceeds Rs. 10,000 then the bank also deducts TDS at 10%. In case the bank does not know your PAN, it deducts 20%. This means that a part of your return is not available for compounding because it is taken out and paid as tax every year. This makes a substantial difference to returns. Capital gains are taxed only when they are realised. Furthermore, if you stay invested in these bond funds for longer than three years, then gains are classified as long-term capital gains and are taxed after indexation. Any good CA will be able to provide the calculations for the same while filing taxes. This does not happen with FDs.

Applying all these factors, a three-year investment in a short-term fund will leave you with almost twice the returns as an FD over the same period, and with excellent liquidity.

If you are willing to forego liquidity with a lock-in of three years, then the type of fund to consider a Fixed Maturity Plan (FMP). These are likely to give somewhat higher returns. However, since liquidity is generally one of the desirable feature of any investment, the previous three types of funds are a better choice.

Going forward, I expect the more knowledgeable and experienced investors to shift away from banking products towards these types of funds.

Connect with your mutual funds advisor and explore these funds and beat the low FD returns.

All the best!