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Despite Tax Tweak, Fixed-Income Funds Still Trump Bank Deposits

Banks may have succeeded in getting tax parity with fixed-income funds, but fixed deposits still lose out on liquidity and returns

The new, tighter taxation rules for bond funds are now a reality. With the changes that have taken place in this budget, one might expect some proportion of investors in these funds to shift to equivalent banking products. After all, the Finance Minister's avowed reason for the new rules was to eliminate the tax arbitrage that existed between bank deposits and fixed-income mutual funds. It's a widely known fact that this change was something banks had lobbied for for a long time. Perhaps with the new government's focus on infrastructure and the funds required, this was one of the things that got done.

Will it turn out that the banks have succeeded in what they set out to do? In other words, will there be a large scale migration from fixed-income mutual funds to banks deposits? While that may seem like the obvious answer for those who are focussed only on the tax aspect, this outcome is not all that certain. In the immediate aftermath of the taxation changes, investors and analysts were vocal in pointing out how much worse off fixed-income mutual fund investors are. But that's the case when you compare these products to their own past. Are they worse off than equivalent bank deposits? Not by any means.

Depending on their exact investment requirements, I think most investors will fund fixed-income funds to be a somewhat better option than bank deposits. At worse, they'll be equally attractive. In no case are they a worse option than bank products. Let's break this down to see what exactly is the reason.

Firstly, the changes in the tax rules affect only investments that are made for a period between one and three years. Those who were investing for shorter or longer periods are completely unaffected by any changes. Typically, a huge proportion of the investments made by corporates to park temporary cash from a few days to a few weeks duration. These investors are completely untouched by the new rules.These investment, which add up to more Rs 2 lakh crore, are from investors who already find fixed-income funds to be a better option than bank deposits despite equal tax treatment.

The main reason why funds--at least open-ended funds--are still superior is on-demand liquidity. Unlike bank FDs, fixed income fund investments can be redeemed at a day's notice without any compromise on returns. Also, investors can start the investment without having to decide what period they are investing for. And, on top of that, the funds generally manage to deliver half to one percent higher returns than fixed deposits. Even with the same tax level, the cumulative effect of these small advantages make them a compelling choice.

So far, these were all the advantages that those investing up to one year got. Now, this threshold has gone up to three years. As far as open-ended fund investments go, this is the deal that investors get. It's not as good as what they used to get, but is still better than the alternatives. Just as the banks wanted, there is now no way of investing in a fixed-income mutual fund that will be more tax efficient than a similar bank products. However, tax is just one part of the reasons why people choose investments. On balance, after taking liquidity, returns and tax efficiency into account, fixed-income mutual funds hold the advantage.

But what is true of open-ended fixed-income funds is probably not true of fixed maturity plans (FMPs). These products, which had become exceedingly popular with retail investors due to their superiority over bank FDs, now have very little advantage for periods under three years. Of course, for periods over three years, they still come out far ahead. With indexation of capital gains, the actual tax incidence is close to zero, whereas with bank FDs, the earnings are still fully taxable interest income.

All things considered, it's only FMP funds of periods from one to three years that have lost some (but not all) of their advantages over bank products. For all other types of fixed-income funds, it still does not make much sense to switch to bank deposits.