Bank fixed deposits offering an annual interest rate of 9.5 per cent for a three-year term may appear to be the safest avenue to park one’s money. However, if one takes into consideration the tax aspect, debt schemes of mutual funds are found to give a better post-tax return than bank fixed deposits.

The annual interest earned on a fixed deposit is added to one’s total income to calculate the income tax liability and will be taxed at the marginal rate corresponding to one’s income bracket. If one is in the 30 per cent tax bracket, one will have to pay tax on the interest income at the rate of 30.9 per cent, including a 3 per cent education cess.

Dividend delight

Dividend income from a mutual fund debt scheme, on the other hand, is tax free. The mutual fund house, though, will have to pay a dividend distribution tax at the rate of 14.163 per cent (including a 10 per cent surcharge and a 3 per cent education cess) on income distributed as dividend to individual investors and Hindu Undivided Family.

In the case of dividend distributed to institutional investors, the rate of dividend distribution tax is 22.66 per cent. The dividend distribution tax in liquid/money market schemes is higher at 28.325 per cent.

However, unlike in a bank fixed deposit, one will have to pay capital gains tax while redeeming the debt fund units. If one redeems the units within 12 months from their purchase, the short-term capital gain will be added to one’s annual income for tax purposes. But if the debt fund units are redeemed after 12 months, one can pay the long-term capital gains tax either at the rate of 10 per cent without indexation or at the rate of 20 per cent with indexation benefit.

Here again, if one buys the units, say in March 2008 (in financial year 2008-09), and sell them in April 2009 (in financial year 2009-10), one can avail the indexation benefit for two financial years and thereby reduce the long-term capital gains tax liability further.

Thus, Rs 100 received in a year as interest income from a bank fixed deposit is actually less on a post-tax basis than a dividend income of Rs 100 from a mutual fund debt scheme. This is because one will have to pay an income tax of Rs 30.90 from the Rs 100 interest earned from bank fixed deposit, while there’s no income tax on the dividend income. Thus, the post-tax interest income from fixed deposits will be Rs 69.10 compared with the dividend income of Rs 100 from mutual fund debt schemes.

Even if the mutual fund house generated the distributable dividend income of Rs 100 and distributed the entire surplus by paying a dividend distribution tax of Rs 14.163, the final payout will be Rs 85.837 which is still higher than the post-tax interest income of Rs 69.10 from the fixed deposit. This return comparison does not include the capital gain of an investor from redemption of units in a mutual fund scheme.

Bond with the best

The capital gain in a debt fund occurs because the price of a bond or debt paper is inversely related to the interest rate — when the interest rate rises, bond prices fall and vice-versa.

A bond or debenture promises to give the coupon interest rate it carries till the maturity when the face value of the bond/debenture is refunded to its holder. A five-year bond with a coupon rate of 8 per cent promises to give an annual interest of Rs 8 for every Rs 100 for five years.

If the market interest rate increases to 12 per cent, one can earn Rs 8 by investing Rs 66.67 elsewhere, maybe in a bank fixed deposit. Nobody will be willing to pay Rs 100 for the bond to earn Rs 8 a year. The bond price consequently comes down to Rs 66.67 from Rs 100. Similarly, if the market interest rate decreases to 4 per cent, the bond price will go up to Rs 200 from Rs 100. Thus, an investment in bond/debenture involves an element of capital gain or loss in addition to interest income and hence is riskier compared with instruments such as bank fixed deposits.

Varying risks

The risk also varies across different debt papers and their tenures. For example, the prices of government securities are more susceptible to interest rate fluctuations than corporate bonds/debentures. A short-term debt paper varies less with the interest rate changes than a long-term debt instrument.

Hence, for debt fund investors, it would be important to see what should be the average maturity profile of the investment portfolio of the scheme. In a rising interest rate scenario, schemes with shorter average maturity give a less volatile return than schemes with longer maturity.

Similarly, returns from G-Sec funds are more volatile compared with other debt schemes. A larger exposure to G-Secs will lead to greater returns in a falling interest rate scenario but also greater fluctuations as G-Secs are most frequently traded and have longer maturities.

Besides, the yield (which is inversely related to price) on G-Secs is generally lower compared with corporate or PSU bonds.

Performance matters

It is also important to note how these funds have performed (see chart). It is seen that in the past 12 months, long-term debt funds gave an annual return between 8.62 per cent and 8.13 per cent compared with 7.50-7.75 per cent by short-term debt funds and 5.14-4.99 per cent by gilt funds. In comparison, the interest rate offered by banks on fixed deposits for one year during this time was between 7.50 per cent and 8 per cent.

Government bond prices have seen a sharp fall since the Reserve Bank of India went into its monetary tightening drive to rein in double-digit inflation. Thus, the yields on these bonds have moved up sharply both at the shorter and the longer end.

The yield on a 1-year gilt has gone up to 9.23 per cent against 7.45 per cent in December 2007. The five-year gilt yield has risen to 9.04 per cent against 7.92 per cent in the same period.

The 10-year gilt yield has risen to 8.78 per cent against 7.79 per cent. The corporate bond yield on a five-year tenure has also shot up to 10.62 per cent against 9.99 per cent in December 2007.

All these show that bond prices are ruling at much lower levels compared with December last year. Interest rates may not move upwards significantly from here. This means that debt funds offer tremendous scope for investors.