Confused between bank FDs and debt mutual funds? Here’s a pro tip

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While debt funds have usually outperformed fixed deposits of similar tenures, mutual funds do not not guarantee returns unlike FDs. Bharat Phatak, Director, Scripbox, suggests investing in debt mutual funds is a better option compared to bank FDs, given their potentially higher returns, tax efficiency and greater liquidity.

Edited excerpts from a chat:
If someone with a moderate risk appetite has Rs 10 lakh to invest, what would be the ideal asset allocation strategy that you would recommend?
Asset allocation is a critical component of any investment strategy. It involves dividing the investment portfolio across different asset classes based on investment goals, risk tolerance, and time horizon. An ideal asset allocation strategy for someone with a moderate risk appetite and Rs 10 lakh to invest could be as follows:

  • Equity mutual funds: 50%
  • Debt mutual funds: medium to long term: 35% & short-term/emergency funds: 10%
  • Gold or other precious metals: 5%

This allocation strategy balances potential returns and risk while providing diversification benefits.

50% allocation to equity mutual funds can provide the potential for higher returns over the long term but comes with higher volatility. 35% allocation to medium to long-term debt mutual funds adds to stable returns with a lower risk profile, and the 10% allocation to short-term/emergency funds can provide liquidity and a safety net for unexpected expenses. Lastly, the 5% allocation to gold or other precious metals yields diversification benefits during market turbulence.

It’s important to note that asset allocation is a personal decision, and investors should consult with financial advisors to create an investment strategy that aligns with their specific financial goals and risk profile. It’s also essential to regularly review and adjust the portfolio to ensure that it remains aligned with the overall goals and objectives in the long run.

Interest rates are likely to rise further in 2023. Should one go ahead and book FD at current rates or wait a bit?
Fixed deposits are a widely popular investment option that provides investors with a guaranteed return over a fixed period of time. The Reserve Bank of India (RBI) has been increasing its policy rates since May 2022, resulting in banks continuously raising interest rates on FDs of varying tenures. However, FD rates are impacted by factors beyond repo rate changes such as liquidity, credit demand, and call money rates, which should also be considered while making an investment decision.
Liquidity is a crucial factor that banks consider when setting FD rates. During times of sufficient liquidity, banks do not rely on retail fixed deposits to stabilize their position. However, during tight liquidity times, banks utilize their deposits to ensure their stability.

Credit demand is another factor that plays a significant role in determining FD rates. When credit demand is high, banks tend to increase deposit interest rates to attract investors. Lastly, call money rates also influence FD rates. Banks resort to call money to fill the asset-liability mismatch, meet the CRR and SLR reserve requirements, and address sudden fund requirements from liquidity demand and supply. As a result, when there is a tight liquidity condition, call money rates increase, ultimately affecting deposit rates.

At present, the credit growth stands at around 16%. The liquidity situation of the banking system is also close to a neutral deficit, and FD rates are on an upward trajectory. While FD rates have increased, it is still less compared to the 2.5% hike in repo rate until March 2023. However, with credit growth picking up in the last six months, banks have begun to raise deposit rates to attract investors. But there is still room for interest rates and FD rates to increase from their current levels, even if not too significantly

It is recommended to stagger investments in order to maximize benefits at this juncture. Whether to book an FD at current rates or wait a bit depends on individual financial goals, risk tolerance, and investment horizon. It is always advisable to seek professional financial advice before making any such investment decision.

What is the significance of the inversion of the bond yield curve for debt investors?
It is crucial to monitor the yield curve as it serves as a significant indicator of economic activity and financial market conditions. In a typical yield curve, long-term bonds tend to offer higher interest rates due to their increased duration risk and longer maturity. However, in an inverted yield curve, the opposite occurs, and short-term bonds provide higher interest rates than long-term bonds.

This inverted yield curve holds great significance for debt investors, as it is often seen as a harbinger of an impending economic recession. Historical trends have shown that an inverted yield curve frequently precedes a recession, leading to reduced economic activity, lower interest rates, and lower returns on investments.

In such a scenario, investors may opt for safer assets, such as cash or short-term bonds, resulting in increased demand for these types of investments. As a result, a decline in demand for long-term bonds and a rise in demand for short-term bonds or cash can impact the returns for debt investors.

In conclusion, keeping a watchful eye on the yield curve is vital for investors seeking to make informed decisions. It is often an early warning sign of impending economic turbulence and can lead to significant changes in investment strategies and outcomes.

In between debt mutual funds and bank FDs, where should one park money at this stage? What is the best way to figure out which debt fund to pick?

Bank fixed deposits have been the go-to investment option for most Indian households. Though, in recent years, debt mutual funds have gained popularity, such investments still remain a small fraction of FDs in terms of household financial assets.

FDs offer compound interest at a fixed rate over the investment term, with interest, typically compounded quarterly. On the other hand, debt funds are market-linked and do not guarantee returns. However, historical data suggests that debt funds have usually outperformed FDs of similar tenures.

When it comes to tax efficiency, debt mutual funds are generally considered more tax-efficient than bank FDs, particularly for individuals in higher tax brackets. This is because interest earned on bank FDs is fully taxable at the individual’s applicable income tax rate, while the taxation on interest income in debt mutual funds depends on the type of fund and the holding period. If an individual holds the fund for more than 3 years, gains are taxed at the long-term capital gains tax rate of 20% with indexation benefit, resulting in lower taxable gains. Short-term capital gains, on the other hand (i.e., a holding period of fewer than 3 years), are taxed as per the individual’s applicable income tax rate.

Furthermore, banks are required to deduct TDS on interest earned on bank FDs if the interest exceeds Rs. 40,000 per annum. In contrast, TDS is not deducted on gains in debt mutual funds. Additionally, bank FDs have a lock-in period, and if an individual breaks the FD before maturity, they may incur a penalty. In contrast, debt mutual funds are more liquid, and individuals can redeem their investments partially or fully as per their requirements without any penalty.

However, it’s important to note that debt mutual funds are subject to market risks, and there is no guarantee of returns. Therefore, individuals should carefully assess their risk profile and financial goals before investing in any fund, keeping in mind the potential tax implications.

Overall, investing in debt mutual funds is a better option compared to bank FDs, given their potentially higher returns, tax efficiency and greater liquidity.

How much retail interest are we seeing towards passive funds? Are they making large-cap funds redundant?
Over the past 6 months, the Assets Under Management (AUM) of index funds such as Nifty, Sensex, Next 50, and other indices have experienced substantial growth, increasing from Rs. 3,62,463 cr at the end of July 2022 to Rs. 4,15,720 cr at the end of January 2023, representing a notable 14.69% growth. In contrast, the AUM of the large-cap category has only grown by approximately 3%, increasing from Rs. 2,31,437 cr to Rs. 2,38,225 cr during the same period.

While the Indian market is currently undergoing significant shifts, with changes in government policies and industry dynamics, among others, there are opportunities for skilled active managers to identify companies that are well-positioned to benefit from these shifts and generate higher returns than the broader market. Therefore, it can be potentially beneficial for investors to consider active management as some large-cap fund managers have the potential to outperform the index.