One of the greatest influencers on how you spend and save, is what your parents did. Mothers who worried about the monthly budget and made you wear hand-me-downs, fathers who wanted to buy the small car because that’s what everyone was doing, a family whose savings consisted of gold in the Godrej almirah: all these still influence our decisions today in how we save, even though the economics have changed.
Take the Fixed Deposit instrument for instance. It’s an old-school instrument that’s been around for a long time, and that all the older generation in our families put money in. FDs however, became a favorite at the time because really, there was no other good option. Stock market reforms in India began in the late 1990s, and before that FDs were the only reliable financial instruments.
But Fixed Deposit accounts today have one of the worst taxation rates, with returns taxed at the normal tax rate. It’s true that the longer the FD time period, the better the rate - but the premature withdrawal fee involved for most Bank Account FDs limits the gains you can make.
Compared to FDs, Debt Mutual Funds hold the key to better returns, are there are broadly 3 kinds of Debt mutual funds which can replace FDs easily at low risk to the investor:
1- Ultra Short Term Debt Funds : These invest in debt paper with maturity of less than a year. These have the lowest volatility and are useful for when you want to park your money for a year or less.
2- Short Term Debt Funds: These invest in papers with average maturity which is typically less that 2-3 years.
3- Long Term Debt Funds or Income Funds: Ideal for investments for over 3 years.
4- Other debt options like Liquid Funds ( lowest risk, lowest returns) , Credit Opportunities (highest risk, highest returns - invest in Corporate bonds) and Gilt funds ( government securities but highest volatility) exist but they are not an exact replacement for FDs so we won't discuss them.
Pro tip: Debt funds also pay trail commission to your broker - so invest directly via the AMC's website and get that extra .5% per year in your account, rather than paying it to your broker.
Fixed Deposit rates have yielded anywhere from 7-9% in the past 5 years. We have chosen to take the average of 8% for the purpose of our annualized yield calculations.
The charts with the calculations are below. Even before taxes, debt instruments give out higher returns than FDs over both the 3 year and 5 year period. The long-term debt mutual funds hit double digits for average and weighted average returns*.
*Weighted average - where the returns are weighted based on the size of money managed by the MF(AUM). This is a better yardstick than ‘average’, since it gives the actual profit made.
What do you get if you put in Rs. 100?
Let’s say you invest Rs. 100 in each of these instruments.The inflation-adjusted value of that Rs 100 after 3 years is Rs 120, and after 5 years is Rs 143. With FDs you barely make any additional gain over inflation - you get Rs. 126 and Rs. 147 after three years and five years from an FD.
After taxes, the amount in FD does not even keep up with inflation, giving you Rs. 118 after three years, and Rs 133 after five years if you are in the top tax bracket. Since Debt Mutual funds are taxed less heavily than Fixed Deposit and also have indexation benefits attached to them, the difference in returns becomes significant.
Over a 5 year term, Short term Debt Mutual funds on average have given nearly 20% more post-tax returns compared to a 8% FD. So while you end up with Rs 133 post tax in case of FD, you would end up with Rs 160 in case of Short Term Debt Mutual funds.
The takeaway from Part 2 is this: as investors, we need to break away from old habits that don’t fit our present investment environment.
In Part 3, I will talk about using PE effectively to measure and reduce the risk you face during equity investing. Read Part 1 of the series here.
