Do consider debt funds before locking money in bank deposits

Updated: Friday, July 20, 2012, 10:18 [IST]

When rates rise, they do so across fixed income products. So it's not just the returns on bond funds that will go up, but the interest offered on term deposits and other such fixed return instruments also follow suit. In the eyes of the retail investor, the tug is between opting for a bank deposit and putting money in a debt fund.

At first blush, term deposits score on the fact that they offer an assured return over a fixed period of time. As of today, 90-day bank deposits offer a return of around 7% p.a. while 1-year deposits yield 9% p.a. But if one takes the tax impact into account, the sheen quickly fades.

A look at the short-term debt funds over the past year indicate that the average returns are in the vicinity of 9.50% p.a. So while they are neck-and-neck in terms of returns, when the tax angle is brought into the picture, income funds emerge the winner.
Interest earned from a bank deposit is fully taxable in the hands of the tax payer. This interest is added to the individual's total income and the tax at the applicable slab comes into effect. If one takes the highest tax bracket into account, the returns fall from 9% to 6.3%. Suddenly, they don't appear lucrative at all. And when you take inflation into account, one is left with nothing.

The tax effect on term deposits
Amount invested (Rs)	Tax slab (%)	Interest @9% p.a. (Rs)	Net interest earned (Rs)	Post-tax return (%)
100000	10	9000	9000-900 = 8100	8.1
100000	20	9000	9000 – 1800 = 7200	7.2
100000	30	9000	9000 – 2700 = 6300	6.3

Which brings us to the question of how debt funds are taxed. Returns on debt funds are subject to capital gains treatment. The short-term capital gain in an income fund is added to the income and taxed according to slabs. In this case, the taxation is similar to that of bank deposits, hence we recommend that you hold your investment for over a year, when long-term capital gains sets in. Long-term capital gains from debt funds (investments held for more than one year), are subject to either 10% flat capital gains tax or 20% after indexation. Taking into account the uncertain interest rate scenario, we are of the opinion that short-term debt funds are the place to park your cash in.

Below is the current list of all the short term funds in the offering from the Indian mutual Funds space and if one looks closely, then he/she is bound to notice that the average returns these funds are generating is in the range of 9-9.5%, which makes them a better and prudent choice for the risk averse investors.

Performance as on July 17, 2012
Scheme	1-year return (%)
Religare STP-A(G)	11.5732
Peerless ST - Reg(G)	10.4972
Tata FIPF A3-Reg(G)	10.4373
Taurus ST Income(G)	10.2759
JM Short Term-Reg(G)	10.1513
Sundaram Select Debt-STAP(G)	10.1078
IDBI ST Bond(G)	10.1029
Pramerica ST Income(G)	9.9903
Tata FIPF C2-Reg(G)	9.9347
Birla SL ST Oppor-Ret(G)	9.9171
Tata FIPF C3-Reg(G)	9.8732
Taurus Dynamic Income Fund(G)	9.8454
HDFC Short Term Opp(G)	9.8001
AIG ST-Ret(G)	9.7836
JPMorgan India ST Income(G)	9.7784
UTI ST Income(G)	9.7779
Tata FIPF B2 -Reg(G)	9.7718
Religare Credit Opp-Reg(G)	9.657
Tata FIPF B3-Reg(G)	9.631
Morgan Stanley ST Bond-Reg(G)	9.4539
Tata FIPF A2-Reg(G)	9.4281
ICICI Pru Banking & PSU Debt Fund-Premium Plus(G)	9.4275
Templeton India ST Income(G)	9.3507
Kotak Income Opp(G)	9.339
DWS Short Maturity-Reg(G)	9.3054
Canara Robeco ST-Reg(G)	9.2062
ICICI Pru STP-Ret(G)	9.1711
IDFC SSIF-ST(G)	9.1632
Kotak Bond-STP(G)	9.1624
HDFC High Interest-STP(G)	9.1124
Tata ST Bond(G)	9.0645
ING ST Income(G)	9.0595
BNP Paribas ST Income Fund(G)	9.0236
HDFC STP(G)	8.959