Can Mutual Funds be a substitute for Bank FDs? Honestly NO- as substitute theory works when two things are identical. The basic nature here is different as FDs give fixed returns whereas MFs are market linked. So ideally MFs can be used to fill shoes, but one must understand the risk & returns of these two products. So let’s see some fact’s when everyone has declared a match – Fixed Deposit Vs Mutual Funds.
This 2 part article not only duel the epic game of Fixed Deposit Vs Mutual Funds, it also tells you options available and which mutual funds are ideal if someone is looking for investing in long-term debt products. Also, we shall deal with taxation issue & know what hurts or make Debt Fund Returns.
And, this is the time when our Senior Citizen visit banks to renew their Life Certificate and take stock of their Fixed Deposit holdings. Banks employee (especially private banks) have started pitching Balance Funds & other funds to provide alternatives. This is suicidal if these products are invested without understanding the risk.
Joke: You know number 1 reason why money is flowing in Mutual Fund
Ans: Because of this chart:
Now, this is quite a hard task for investors, especially those in the higher tax brackets, to earn a positive real return on their safe investments. Which means a return on inflation and a decent capital appreciation.
Many will argue that with the recent CPI inflation is at 2 percent plus average and one will still make a real return of 200 basis points. But this is a myth for two reasons.
One, the actual Inflation is higher than the official CPI RATE.
Two, recently inflation readings have not included rising prices of oil since last one month.
Therefore, their post-tax returns need to be above 6%.
But still, 6% is not enough, because:
This is taxable.
6% does not help us reach long-term goals.
Option in hand
Falling returns on safe instruments like Bank FD, PPF, Senior Citizen Savings Scheme make this an ideal time for fixed income investors to explore debt mutual funds as an alternative or addition to their Portfolios.
Retirees & pensioners can use debt funds as a supplement to bank FDs to earn more tax efficient regular income. They can explore the new options to get monthly income.
Young investors with long-term goals can park the debt portion of their portfolios in debt funds, instead of banks or small saving schemes, for better growth prospects.
So what option does Fixed Income Investor have in Mutual Funds?
Gilt Funds: The funds invest in Government & State issued securities. High return High Risk Product. Very sensitive to economy rate changes.
Income Funds: The funds are also a diversified category in Debt Funds. They invest in Government Securities, Corporate Bonds, Non-Convertible Debentures, Short Term Bonds. High return High Risk Product. Very sensitive to economy rate changes. But they are managed with 2 strategies:
- Accrual: The fund manager locks in highest-paying securities and does not trade them. The interest component takes care of the return. Buy and hold is the key.
- Duration: The fund managers take a call as per rates in the economy. The relationship between interest rates and price of securities is inverse. So during rate rise, they decrease the portfolio maturity. So they shift to small duration bonds or securities maturing soon. When rate decreases they duration is increased. The aim is to earn from the rise in the price of the bond.
Duration is a risky strategy as it depends on fund managers ability to predict rate changes. It also becomes risky when rate changes are too fast or too slow. This fund also become volatile when rate peaks or bottoms and reversal may take 6 to 12 months.
Currently, we are in such situation. Rates have bottomed and hence few fund manager thinks there might be the last cut. So they are sitting at still high maturity but rate cut still does not look in sight.
Dynamic Funds
They work for both accrual & duration. They may take concentrated bets on one kind of securities. But again fund manager and the team need to predict future movements.
Short-Term Income Funds
These are exactly like long-term income funds with the only difference that the maturity of the portfolio will be less. So they invest in short-term securities & bonds and only allocate small portions to G Sec. Ideal for 1-3 year horizon and during the time of uncertainty in interest rates.
Ultra Short Term/Money Market Funds
Ideal for 7 days to 365 days. Different funds exist so that you have a choice for 6 months or more requirements.
New Options
Corporate Bond Funds
Ideally these funds invest in bonds issued by corporate or companies. When a company needs fund it goes to equity or debt markets. Issuing equity shares means you dilute the present holding stake, so they prefer debt. It’s a fixed rate security or FD issued by companies who require money.
These funds are also called Credit Opportunity funds. The rate at which a company takes money depends on its credit quality. So a better business will pay less and moderately managed or a new entity can give more returns but their business may be disrupted in future.
Predicting these company’s financial position for more than 1 year is a risk. As business situation might change. Look at the change in Reliance ADAG companies. So the rates offered depends on company’s rating. A good company will pay low rate but it is certain to pay. A low rated company will offer high rate and may delay or default payment. It happened with Amtek Auto & JP Associate recently. These funds are generally accrual funds but many times fund managers play between different rating bonds. Credit opportunity strategy works like this.
Equity Arbitrage or Equity Savings Funds
The capital gain duration and rates are different for Debt & Equity. So in these funds, the Equity + Arbitrage is maintained above 65% of the portfolio. This means this is a debt fund but have equity taxation. Now, this is a loophole and SEBI has already identified it. So in recent Rationalisation & Categorization of MFs, they are bound to address it. Anyway, it is an option today.
Balance Funds
These funds are hybrid of equity and debt. The rule says 65% of an average should be in equity to qualify as an equity fund. Fund house manages that using arbitrage. Why I have put them in new option is that many of them have monthly dividend payment option now. The dividend is tax-free. One must not think that dividends are compulsory for them. It depends on MF company. Also, they can declare a dividend on earnings and reserves only. So when equity markets will go down for long period, dividends will reduce or vanish.
MIP or Monthly Income Fund
Don’t go by the name. The name helped countering post office monthly deposit scheme. They have equity from 5% to 40%. So some are aggressive MIPs and some called conservative MIPs. They also have monthly dividend plans. There is no guarantee of rate and frequency of dividend. You will see some action here as all AMCs are trying to pitch these as equity markets are up and in the costly zone.
So now we know the weapons and the battleground. But the edge of these weapons depend on Economy, Interest Rates, Product features & Taxation. Let’s take this war of fixed deposit vs mutual funds to next level.
So in next post lets see what effects debt fund and how we should choose a right fund.
Monday you shall receive the fixed deposit vs mutual funds Part 2.
Till then share your views & queries here. Also, share this article so that more investors get information.
