RBI is always faced with the issue of either curtailing inflation or promoting growth. But early this year, after it announced a cut in the interest rates, it seems, it is opting for a more aggressive growth option.

It is at this point that the investor is faced with a dilemma, should he invest his money now in fixed deposits to safeguard his capital or should he invest in debt funds, thus taking advantage of falling interest rates. If this sounds like technical jargon, let me simplify this for you in the following paragraphs.

investment

An investor can either invest his money in bank deposits or in debt or debt mutual funds. Let us look at what each one of these is.

Bank deposits:

Banks offer two types of deposits: savings deposits and fixed deposits. Most banks offer 9.5 % interest rate on fixed deposits for a period of 1, 3 or 5 years. Senior citizens enjoy an additional 0.5% interest rate. However, these rates are subject to change as per the government’s discretion. Saving bank deposits offer around 4-6% annual returns.

Debt funds:

Debt funds are managed by a fund manager. He then decides to invest the money in fund instruments issued by the government, banks and different companies. He studies the financial scenario before parking the money. When interest rates fall, debt fund prices increases.

There are various types of debt funds depending on the term of investment and risk appetite of the investor. Let us look at the types of debt funds in the market:

Different Types of Debt Funds

Name of the fund Term of investment Where is the money invested Objective of the fund
Liquid funds Very short Money market instruments Safety of capital
Short term funds 5-6 months Money market instruments with higher return Safety of capital with higher return
Income funds Medium term Corporate and government bonds and money market instruments Safety of capital and regular income
Government security funds Long term Government securities Safety of capital
Fixed maturity plans Varying maturity periods Like bank fixed deposits Guaranteed returns
Floating rate funds Varying Market related securities Market related returns

Now that I have made the concept of a bank deposit and debt fund clear, we can look at the issue of where is it more prudent to invest your money, given that interest rates are witnessing a downward trend.

There are times when the investor can lose almost his complete principal amount when invested in debt funds. However this is not a possibility if the investment is made in bank fixed deposits or in government securities. Secondly, depending on the interest rate changes, some fluctuations might occur in the rate of return.

When Interest Rates Increase

When the interest rates go up, debt fund values go down. In such a case the investor feels fixed deposits to be a better option where he can enter the market at a better time when are the interest rates are nearing a top.

The debt fund investor feels this to be a loss of opportunity when interest rates are moving up and his debt funds are doing just the opposite i.e falling down.

When Interest Rates Decrease

But when the interest rates fall, debt fund prices increase. At this point of time, debt funds seems to be an ideal option because the debt fund investor can take the advantage of falling interest rates when his debt fund prices would increase with the falling interest rates. On the other hand, fixed deposit investor might get lesser returns as compared to a debt fund investor because he would be investing his money at lower interest rates when the rates are falling and he would get the return at the same rate for the whole tenure, the rate at which he invested initially

Besides considering these risks, an investor should also look at the tax implications in debt funds and bank deposits. It is better to put money in long term debt funds from this perspective because dividend income is tax free and long term capital gains tax stands at 10% and 20% with indexation. However if the investor redeems his investment before one year, he has to pay the stipulated tax. Also he might have to pay a dividend distribution tax of 16.845 if he opts to take the dividend option.

Therefore in this current scenario of falling interest rates the investor who can afford to take some risk should opt for some long term debt funds to capitalize on the prospect of better returns. Also since long term funds invest in different securities, it is the best way for a retail investor to diversify his investments.

[This post has been written by Mayank Gupta and he writes a financial blog on equity mutual funds and income taxation]

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