Bank deposit or debt fund?

By Mohasin Athanikar |  22-10-20 | 
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About the Author
Mohasin Athanikar is an Investment Analyst for Morningstar Investment Adviser India.

Instead of investing in a bank recurring deposit with a low interest rate, I thought of investing in a debt fund. My time frame is 36 months. I would like to invest Rs 10,000 per month. What type of fund must it be?

Since 2019, the Reserve Bank of India, or RBI, has cut the policy rate sharply and announced a slew of measures to boost lending and mitigate the consumption-led slowdown in the economy, which recently got further aggravated due to the COVID-19 pandemic.

The measures announced along with abundant liquidity in the banking system have resulted in yields falling substantially, particularly at the shorter end of the yield curve. Consequently, the yield-to-maturity on fixed-income mutual funds too have come off, particularly in the case of the shorter duration categories.

Banks too have cut down on deposit rates. In order to protect their margins, it is expected that they pass on the reduction in interest rates to deposit holders and borrowers. Currently, deposits of leading public sector and private banks offer interest rates in the range of 5.4%, with an additional 50 bps for senior citizens. This does not even beat the rate of inflation. In August, consumer inflation was 6.69% and surged to 7.34% in September.

Compared to bank deposits, mutual funds do offer favorable taxation for holding periods over 3 years, wherein only the gains are taxed at 20% post indexation of cost. However, in the case of shorter holding periods (up to 3 years), the gains are added to an investor’s income and taxed at the marginal rate.

Also, mutual funds being actively managed, have the potential to generate higher returns than the interest rates offered by bank deposits. However, one should be cognizant of the inherent risks in debt mutual funds such as interest rate risk, credit risk and liquidity risk which can subject the portfolio to significant drawdowns as witnessed in recent times.

In the case of a bank deposit, the maturity amount is known at the time of investment, unlike that of a market-linked investment such as a debt mutual fund. The potential for return is higher, but not guaranteed.

Given your time horizon of 3 years and the monthly contributions of Rs 10,000; the tax treatment in case of gains from both - mutual funds and deposits, would be similar. Gains from each contribution would be taxed at the marginal rate. If you want surety of returns, you may consider investing in a bank deposit. If you are a senior citizen with taxable income, interest income would be tax deductible up to Rs 50,000 per annum, under Section 80TTB for senior citizens.

If opting for mutual funds, you can consider accrual fixed income funds with a high credit quality portfolio such as Banking & PSU debt funds, Corporate Bond funds, and Medium-term funds.

Assuming a return of 5.5% per annum, investing Rs 10,000 per month will give you about Rs 3.9 lakh at the end of 3 years. To attain a higher corpus, you can increase the monthly contribution every year.

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