Five reasons to invest in Debt Mutual Funds

Ramya R Iyer, 26/6/13 Economic Times


While debt mutual funds offer several advantages, very few small investors put their money in these instruments. Here is the list of the reasons that make these funds a better investment choice than other options in the fixed income space.

1) More liquid than FDs

A debt fund is very liquid—you can withdraw your investments at any time and the money is in your bank account the next day. Unlike a fixed deposit, the fund house does not levy a penalty for exiting too soon. Some funds have an exit load if the investment is redeemed within 3-6 months. However, most debt funds don’t levy a charge if the investment is redeemed after one month. Besides, you can make partial withdrawals, without having to break the entire investment. Also, the procedure for breaking a fixed deposit requires more paperwork than a click of a mouse.

2) They are more tax efficient

In the long term, debt funds are far more tax efficient than fixed deposits. After one year of investment, the income from a debt fund is treated as a long-term capital gain and is taxed at either 10% or at 20% after indexation. In indexation, the cost of investment is raised to account for inflation for the period the investment is held. The longer you hold a debt fund, the bigger is the indexation benefit. There is also no TDS in debt funds. In fixed deposits, if your interest income exceeds Rs.10,000 a year, the bank will deduct 10.3% from this income.

If you are not liable to pay tax, you will have to submit either Form 15H or 15G to escape TDS. The other problem is that the income from fixed deposits is taxed on an annual basis. You may get the money after the deposit matures 5-6 years later but the income is taxed every year. In debt funds, the tax is deferred indefinitely till the investor redeems his units. What’s more, the gains from a debt fund can be set off against short-term and long-term capital losses you may have made in other investments.

3) You don’t lose even a day’s growth

You don’t lose even a day’s growth when you invest in an open-ended debt fund. If you invest in a fixed deposit or a closed-ended fixed maturity plan, you get a lump sum amount at the end of the term. Hectic work schedules and busy lifestyles mean you may take some time to encash the fixed deposit and then reinvest the proceeds. In some cases it could be even a month or two before the money is redeployed. That can be a drag on the overall returns. Besides, there is no telling what the prevailing rate of interest is when the investment matures. In a debt fund, there is no such problem because the investment never stops growing till you redeem it.

4) Your returns can be higher

The pre-tax returns from debt funds are comparable with those from other debt options such as fixed deposits and bonds. But if there are changes in interest rates, your debt fund could give higher returns. Short-term debt funds are not affected too much by rate changes. Generally, their returns are aligned with the prevailing fixed deposit returns and the investor gains from the accrual of interest on the bonds in the fund’s portfolio. But funds that invest in long-term bonds are more sensitive to changes in interest rates. If interest rates decline, the value of the bonds in their portfolio shoots up, leading to capital gains for the investor. While the average short-term debt fund has given 9.5% returns in the past one year, many long-term bond funds have risen by more than 12% during the same period.

5) They offer greater flexibility

Debt funds are also more flexible than fixed deposits. You can invest small amounts every month by way of an SIP or whenever you have surplus cash. Can you imagine opening a fixed deposit every time you have an extra Rs 2,000-3,000 in your bank account? Similarly, you can start an SWP to withdraw a predetermined sum from your investment every month. This is particularly useful for retirees who want a fixed income every month. You can also change the amount of the SWP whenever you want.

Another key advantage is that you can seamlessly shift the money from a debt fund to an equity fund or any other scheme from the same fund house. If you have a substantial amount to invest, put it in lump in a debt fund and then start a systematic transfer plan to the equity scheme you want to buy. Compared to the 4% your money would have earned in the savings bank account, it has the potential to earn 9-10% in the debt fund. The icing on the cake is that there is no penalty if the STP stops due to insufficient money in your debt fund.


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