If you are looking to make deposits of a year or so, you should choose fixed deposits (FDs) over debt funds. With the series of interest rate hikes in the last few months, including earlier this month, FDs have become very attractive. On the contrary, owing to the fact that interest rates and bond prices are inversely related, return from debt funds have fallen.
While one-year deposit rates are at 8-9.55% (higher for senior citizens), category average returns provided by various types of debt funds for the same tenor are in the range of 3.98-6.82%, according to data from Value Research, a mutual funds tracker. The highest returns were from ultra short- term funds, and gilt funds in the medium and long-term category gave the least.
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Since the beginning of 2011, the Reserve Bank of India (RBI) has increased both repo and reverse repo rates by 100 basis points each. RBI lends to commercial banks at the repo rate and accepts deposits from commercial banks at the reverse repo rate.
With the rise in interest rates, bond prices have fallen and, in turn, have resulted in lower net asset values (NAV) of debt funds. On the other hand, banks have increased lending as well as deposit rates to tide over their increasing cost of funds due to hike in policy rates.
What’s in store
With inflation expected to remain high, there may be more monetary tightening in the offing and that, in turn, may hit the performance of debt funds further. Says Arvind Chari, fund manager, fixed income, Quantum Asset Management Co. Pvt. Ltd, “If RBI tightens policy rates on account of rise in inflation, debt funds’ performance will be adversely affected. But if inflation remains at the current level and still RBI tightens policy rates to tame inflation further, yields would not harden much from the current level and debt fund performance would not worsen much.”
Slight post-tax edge
FD proceeds are taxable in your hands. So if you are in the highest tax bracket of 30.9%, your effective return from an FD giving 9.5% will come to about 6.5%.
On debt funds, you pay long-term capital gains tax of 11.33% without indexation or 22.66%. So on a rate of 7%, your post-tax return would come to around 6.2%.
What about very short terms?
For very short tenors, about three-six months, you would be still better off in a debt fund. Liquid funds and fixed maturity plans of short tenors are able to realign themselves better to the changing interest rate scenario. According to Value Research data, short-term funds, ultra short-term funds, liquid funds and income funds have provided absolute returns of 2.31%, 2.17%, 1.96% and 1.88%, respectively, over three months. On the other hand, bank deposits of three months would provide an absolute return of 1.25-1.75%.
Graphic by Sandeep Bhatnagar/Mint