labels: investment - general, mutual funds
Investment options for the ''risk-averse'' investornews
26 May 2006
Money in bank FDs can actually lose value over time, says Sanjay Matai. He examines fixed maturity plans from mutual funds as an alternative.

A fixed deposit in a bank has been one of the most common forms of investment for the risk-averse investor. Two key factors that make bank FDs one of the most preferred investment options are:

  • Safety
  • Fixed and assured returns

And, let us not forget the high interest rates these deposits offered till a few years ago; one could easily earn an interest of around 10 to 12 per cent per annum. Given a scenario of high and secured returns, there was no reason to look at alternate investment options.

But we all know that things are different today. The last few years has seen a rapid rationalisation in India's interest rate regime, and bank interest rates have dropped sharply. Even the government has substantially reduced the interest on its small savings schemes like PPF, NSC, KVP, etc.

Today, one can expect to earn only about 6 to 6.5 per cent interest on a one-year bank FD. Further, this interest is fully taxable. With inflation at around 4.5 to 5 per cent, the post-tax return from a bank FD does not even cover inflation. Therefore, with time, the money in a bank FD is actually losing value.

Therefore, risk-averse investors urgently need alternative investment opportunities. These options should provide better returns than a bank FD, without compromising on either the safety of the funds or the reasonable assurance of fixed returns.

Debt-based fixed maturity plans
Offered by the mutual funds, debt-based fixed maturity plans are one such alternative. Let us analyse how best can they meet our investor's objectives.

Safety: The corpus of these plans is invested in 'AAA' and 'AA' rated debt instruments. This provides good safety against credit default, which is one of the risks affecting the safety of funds. The risk profile of such investments more or less match bank FDs.

Assurance of returns: Apart from credit risk, the other risk that could affect returns is interest rate volatility. This risk is mitigated by investing the corpus in debt instruments that mature in line with the maturity dates of the fund. There is, therefore, a reasonable amount of assurance about the returns.

Liquidity: Fixed maturity plans are available with varying maturities - monthly, quarterly, half-yearly, annual, etc, which matches with bank FDs.

From the point of view of safety, liquidity and assurance of returns, therefore, fixed maturity plans more or less match bank FDs.

We now come to the most important point - the returns. The tax treatment available to mutual funds is more advantageous than bank FDs. This makes their post-tax returns of mutual funds far more attractive than bank FDs.

A typical one-year bank FD rate today yields around 6.5 per cent, while a one-year FMP is likely to give around a 6 per cent return. The comparative post-tax returns under the two options is given below:

      One year Bank FD
MFs 1 Ye FMP
  
Growth Option
Dividend Option Without
Indexation
With
Indexation

Amount invested

100

100

100

100

100

Interest / Yield

6.50%

6.50%

6.00%

6.00%

6.00%

Value at end of 1 year

106.50

106.5

106.0

106.0

106.0

Returns

6.5

6.5

6.0

6.0

6.0

Indexed cost *

NA

NA

NA

NA

104.5

Indexed Gains

NA

NA

NA

NA

1.5

Tax Rate

20.40%

30.60%

14.03%

11.22%

22.44%

Tax amount

1.326

1.989

0.7382

0.6732

0.3366

Post tax resturns amt.

5.174

4.511

5.2618

5.3268

5.6634

Post tax resturns %

5.17%

4.51%

5.26%

5.33%

5.66%

(* assuming indexation 4.5%)

From the above calculations, it is clear that an investment in a mutual fund gives better returns for persons in higher tax brackets.

Another factor favouring mutual funds is tax deduction at source (TDS). Since TDS is not applicable to mutual funds, it becomes a simpler proposition than bank FDs, where investors have to face the problems of TDS being deducted from their interest earnings.

On a number of parameters, therefore, fixed maturity plans of mutual funds are a better option than bank FDs for the risk-averse investor.


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Investment options for the ''risk-averse'' investor