Debt mutual funds or bank fixed deposits?

Over a period of one year there has been a steady rise indeposit rates, which have risen to as high as nine per cent plus. The reasonfor the high deposit rates is the prevalence of a high interest rate regimecaused by a liquidity crunch and rising inflation, which warranted action bythe Reserve Bank of India (RBI).

Further, given that crude oil prices are hovering above $100per barrel there are expectations that interest rates could further rise byanother 50 basis points from the existing levels. This may happen in twotranches though.

Moreover, due to the tight liquidity conditions faced bybanks in the short term banks have been constrained to raise their interestrates to make investments in fixed deposits (FDs) more attractive.

In the race to attract investors, mutual fund houses alsooffer investors products that suit their needs like Liquid Funds , Ultra ShortTerm Liquid Funds, Short Term Bond Funds and Fixed Maturity Plans (FMPs), whichhold out the hope of being able to provide investors with a return of about 9 to 10 per cent.

So, what factors should a debt investor (which is what mostIndian investors predominantly are) weigh while making a choice between an FDand a debt mutual fund? The biggest plus that a bank FD has over a debt mutualfund (short term) is that they give a fixed rate of return. However, the post-tax returns are much lower as the income earned by way of interest is clubbedwith the income of the individual and taxed. Also, if the money is withdrawnbefore the lock-in period a penalty is charged for early redemption. Thus, formost individuals falling in the highest tax bracket, FDs are not the mostlucrative option.

The tax efficiency of debt mutual funds puts it at anadvantage, making it an appealing investment option as the tax levied by thesefunds on capital gains is much lower than that of FDs.

These funds are fraught with risk as the returns are linkedto fluctuations in interest rates and the resultant market volatility.

Also, debt funds offered by various AMCs offer high amountsof liquidity and thus suit the needs of those investors who want to park surplusfunds for a specific time frame or are yet to make a provision for theirfinancial goals without sacrificing on the opportunity of making money even inthat short period.

However, in addition to choosing a debt fund that is idealfor the tenure one chooses to remain invested, investors must also keep in mindcertain factors while making a selection.

Investors must choose the fund which has the least expenseratio as the portfolios would be identical to a very large extent.

Also, consider whether the fund house charges any exit load,as some fund houses have a minimum period during which one must remaininvested. Investors need to keep an eye out for funds which have a loweraverage maturity and duration as they are less sensitive to interest rate changes.

So, given the likely rise in interest rates, investors in ahigher tax bracket can invest in debt funds to get an edge over FDs in terms ofnet of tax returns.

(Ashok Kumar ispromoter, theIPOguru. com & director, Lotus Knowlwealth)