A few days ago Subra called me to discuss a calculator idea: a comparison between a lumpsum investment made in a bank fixed deposit and a debt fund, like a income fund, over a period of several years.
Interest from a bank FD has to be declared each year and will be taxed according to slab. Whereas taxation is deferred until redemption for a debt fund and is either a flat 10% or 20% after inflating the initial investment using the cost inflation index. The 20% option typically implies lower tax and if inflation is high there could be capital losses instead of gains!
This key difference between a FD and a debt fund implies that more money is available for compounding each year. So over a long period of time there can be big difference in the corpus. In fact a debt returning 7.5% can still outperform a FD returning 10%! Of course there is more risk associated with a debt fund than an FD but over a long period of time (say 10 years) this risk should be minimal.
Here is the article by Subra which explains this with an example:
Advantages of debt funds over fixed deposits
Here is the calculator based on this idea to compare returns of a FD and a debt fund. The options are fairly straightforward. Play around with it and let me know what you think.
Download the FD vs debt fund returns comparator
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Dear Pattu, good job. Not many people are aware for this tax arbitrage thing. A majority of public thinks that MF means Eq. investment only. One more interesting Tax arbitrage thing associated with MFs (specially Debt funds), Paying STCG tax @ 30.9% is better than paying dividend @ 27.5%. Amazing but true. I hope you know it already.
Thanks
Ashal
Thanks Ashal. I have no prior experience with dividend taxation so I don't know about this. If you could elaborate we could make a calculator out of it!
Hi Ashal,
After DDT, it works out to approx 24% less than 1 year from june 1st.
Abhishek
Very nice comparison of debt funds over fixed deposits! I downloaded the excel sheet and it was pretty amazing!
Thanks a lot Ayush
Superb article, Pattu! I'm fortunate to be in your mailing list!!
Thank you so much. Full credit to Subra. Also thank to people like you comment regularly and keep my spirits up.
I found your point about taxation in debt funds being applied only at the end very useful. Thanks for that. But do we have a debt fund which reliably gave FD like returns for long periods like 1o yrs in a row.. Because I don't want to switch debt funds every year based on performance and then face the same taxation problem (which fd faces). I will now try to find such a debt fund.. give me some time
It is Subras point actually. Yes finding a good debt fund is important. An income fund like Templeton India income has returns 8.9% since 1997 which is pretty good. Of course there will be some volatility in returns. As long as the deviations are not significant wrt to prevailing FD rates (up to about 2%) debt funds will do better. Even a liquid fund which returns 6-7% (safest of them all) will still fare comparable with a FD if not better.
Thanks Pattu. I think the greatest gift that you can give to an individual is a new idea. You and Subra has given that to us. Now I was trying to find a 'good' debt fund. I can think of following parameters:
1. Last 10 yr return
2. Less Std. deviation
3. Less churn in who the Fund manager is
I know the adage 'do not drive looking at the back mirror' but is there any other way to judge the performance of a fund without looking at the past?
Do you have any other filters that I can look for?
The rear view is the only view available. So we need it. Just that we should remember not to cloud the windshield with that view.
For a debt fund the average maturity of the holdings should match the investment tenure. Also exit loads need to be kept in mind. Rest is gamble which should be monitored closely
Dear Pattu,
We can use your calculator to compare FD returns vis-a-vis tax-free returns from employees provident fund.
1) we can mention 0% instead of 5% against "rate of annual increase in cost inflation index",
2) corpus from fixed deposit will be calculated automatically,
3) "corpus from debt fund (pre-tax) will be our tax-free corpus from provident fund.
Now, let's take principal amount as Rs.1,00,000. We also assume, a)Income Tax slab of the individual as 10%, 20% & 30%, b) FD interest rate as 9.5%, c)tax-free interest rate of epf as 8.5%, d)number of years of investment as 9 years.
At 10% tax slab, the corpus accumulated from FD(post-tax) and epf is almost same, 2.08 lacs. At 20%, post-tax corpus from FD is 1.92 lacs and at 30%, it is 1.77 lacs.
The corpus accumulated from 8.5% tax-free interest of epf remains the same at about 2.08 lacs.
Clearly, epf scheme is a boon for those individuals who come in tax slabs of 20% and 30% but not good enough for those in the 10% tax slab!
Dear Pattu, I may be saying the obvious and have jumped the track from "debt funds" to epf, but I just wanted to see if the calculator could be useful for other comparisons as well! Have I used the comparator correctly?
Idea-wise you are correct. However to use this calculator you would need to
set the "rate of annual increase in cost inflation index" = interest rate of EPF so that the returns are tax -free. Of course you should then ignore the 'post-tax without indexation' result.
I was asked to make a calculator comparing two different products in general. I will do this soon.
Great work Pattu. Now I know how much i can save additionally if I invest in Debt funds. I think its peoples tendency that Bank FD's are much safer than investing in MF. They just want to protect their investment.
Keep up the good work.
Thanks. All credit to Subra.
Dear Pattu,
I'm sorry to trouble you but I have not understood. If “rate of annual increase in cost inflation index” = interest rate of EPF(8.5%), what rate or figure should I put against "Interest rate on debt fund (eg. Income Fund)" ? According to you, what value would I get as tax-free corpus from epf?
In any case, I'm eagerly waiting for your calculator comparing two different products in general!
No issues. The calculators get better only because of such ideas.If you want to use this calculator for EPF by replacing the taxation properties of the debt then it has to be done as mentioned above.
First choose a comfortable rate of interest for debt fund( ie. EPF)
then just set the same no for rate of increase in cost inflation index. You will then use the post-tax corpus with inflation is the same as pre-tax corpus.
Ignore the ‘post-tax without indexation’ result.
I will first sent the calculator comparing two different products in general for your feedback before publishing it.
Thank you very much for your time.
Thanks for the calculators. I'm going to try the others posted on your blog as well!
That would be great. I will await your feedback.
Dear Pattu,
I'm not great with numbers and my idea was to use your latest calculator to compare Fixed Deposit realisation vis-a-vis EPF tax-free realisation. I seem to be differing with you as follows:
1) Against “Interest rate on debt fund (eg. Income Fund)”, I should mention the EPF rate of interest, which is, around 8.5%.
2) Against "rate of increase in cost inflation index", I must mention zero as CII is irrelevant for tax-free EPF interest.
3) Now, the only two values I have to check are: (a) corpus from FD (post-tax), and (b) pre-tax corpus from debt fund (in my case, EPF).
4) I have to ignore indexation completely since, in case of tax-free EPF interest, it is not relevant.
Hence, the corpus accumulated from 8.5% tax-free interest of epf remains the same at about 2.08 lacs after 9 years.
However, in case of Fixed Deposit, I quote from my earlier post:
"Now, let’s take principal amount as Rs.1,00,000. We also assume, a)Income Tax slab of the individual as 10%, 20% & 30%, b) FD interest rate as 9.5%, c)tax-free interest rate of epf as 8.5%, d)number of years of investment as 9 years.
At 10% tax slab, the corpus accumulated from FD(post-tax) and epf is almost same, 2.08 lacs. At 20%, post-tax corpus from FD is 1.92 lacs and at 30%, it is 1.77 lacs."
"Clearly, epf scheme is a boon for those individuals who come in tax slabs of 20% and 30% but not good enough for those in the 10% tax slab!"
Am I right or wrong? Thanks!!
I agree with
“Clearly, epf scheme is a boon for those individuals who come in tax slabs of 20% and 30% but not good enough for those in the 10% tax slab!”
Reg. ignoring indexation
as long as you use "pre-tax corpus from debt fund (in my case, EPF)"
it is correct.
Indexation can ALSO be ignored by just leaving it as it is.
Thanks, Pattu! Now we wait for the new "general comparator" that you are developing and we shall re-try such comparisons on that.
Do you have a good suggestion of such a debt mutual fund? I got the list of such MFs which are at least 10 yrs old and accept < 1L in investment. They are 150 in number. I am not stuck in analysis paralysis. 🙁
If you want to invest in a debt fund for a long period of time and reduce risk best is use a fund with much lower maturity duration.
For example if you want to invest for more than 10 years then choose income funds (3 yrs or so maturity) or if you want lower risk (and hence lower return)
short-term funds (1-3 yrs).
Examples
Templeton India Income-G
Reliance Regular Savings Debt -G
Canara Robeco Short Term
I will soon do a post on choosing a debt from using VR online
I would like to leave the maturity duration decision to my fund manager. He should be able to take a call based on the interest scenario..
You are missing the point. With the exception of dynamic bond funds, debt funds are classified in term of maturity duration of the underlying debt. If you enter a liquid fund the maturity date will never be more than 3 months. As long as my need is well above the maturity date the risk is very small. So for a 20 year period no doubt you could enter a fund like long term gilt but an income fund with about 3 yrs maturity will considerably lower risk.
do we have such funds where if the fund manager wants he can invest in short term and if he wants he can invest in long term based on the interest scenario? Or once the fund is 'branded' short term, he can never buy a longer term script?
Yes there are. These are called Dynamic bond funds. They can swing from short-term maturity to long-term maturity depending on interest rate movements
I have collated some information from VRO and kept it here: https://www.dropbox.com/s/oj9o71tamlcfo4u/Debt%20funds.xlsx
I was able to zero in on 29 odd funds which have a good ranking in 3, 5, 7 and 10 yr returns. I didn't want to take Standard deviation since VRO considers only the last 3 yrs for the same. Let me know what you think.
Nice work! I am not sure what you expect. The key to choosing a good debt fund is to be clear and your investment horizon and choose a fund with
1. much lower maturity value and
2. good underlying debt (based on ratings)
3. decent past performance.
I will look at a few funds and just go with one. Short-listing 29 and hoping to choose from that is over-thinking to me.
My concept of debt is a little archaic. I cannot stomach volatility in debt. So I am happy to choose liquid funds/short term funds and not worry too much about the rest.
Dear Anshuk, let me share my observation from your dropbox file. Most of the time you have opted funds where ER is more than 1. Well in case of Eq. to earn 12-15% return an ER of more than 1 is OK but in case of debt fund, where the growth is limited, such high ER is not acceptable. Please invest in funds where ER is less than 0.5 or at beast 0.6%. A continuous long term return of 7-7.5% is better than 9% one year & followed by 6% next year.
Thanks
Ashal
Thats a great thought Ashal. Currently I shortlisted 24 funds based on their 3, 5 and 7 years return.. so that I can get a fund which has performed consistently. Now I have started going through these fund portfolios and started reading a lot about things like SOV, CBLO etc terms that I see in these portfolios. I am leaning towards funds which have equal amount of CBL (gilt) and company debt.. Pure Gilt is risky too. Anyways, thanks again to Subra and Pattu for this great idea.
Remarkable issues here. I'm very satisfied to look your article. Thank you a lot and I'm looking forward to contact you.
Will you please drop me a mail?
Pattu ji,
I am now in midst of selecting Debt fund(s) to complete the fixed income component of my portfolio.
I have been advised to go for Hybrid Debt aggressive & Debt income for fixed income component. This will take care to park some funds as Emergency corpus and as well debt component of investment portfolio.
Were you able to write a blog on how to choose a debt fund from using VR online ? I was thinking to move ahead using the guidelines.
Hi Vinay, Have received several requests. Will get to this asap.
Thank you Pattu ji for taking up the request. However i would like to contribute 2 paisas.... Is it a good idea to include the Standard Deviation and Debt paper maturity time period along with past returns ? Goal based approach towards debt options would help to select funds.
Yes I will do that.
Sir,
How would the capital fluctuate if interest rates were to rise?
Thanks,
Vaibhav
Please read more this here: Understanding Interest Rate Risk in Debt Mutual Funds
have you considered quarterly compounding while calculating return from an FD (or say a post office deposit)?
Don't remember. Probably not. Will not change arguments by much anyway.
Dear Pattu, another very important post! Thanks for spreading awareness about this. The biggest distributors i.e.the banks don't sell these funds aggressively as it is a direct hit on their CASA deposits.
One correction though: for LTCG, the 10% tax option is no longer available after changes in debt fund taxation in the 2014 union budget. The only option is 20% with indexation. I guess the error owed to the fact that the original article by Subra was written in 2011.