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Optimising fixed-income returns

The problem with fixed income is not just low returns, but high tax. Fortunately, there's a solution

Optimising fixed-income returns

Last week, the Reserve Bank refused to lower interest rates, despite - or so the news informed everyone - there being a widespread expectation that it would do so. As is usual when something like this happens, there followed a noisy discussion about interest rates, inflation and growth. It was more or less a repeat of numerous such discussions over the past decade, neither overly useful or entertaining.

Disappointingly, just as in the previous rounds of this same identical discussion, there was little attention paid to the function of interest rates as the sole source of investment income for a large proportion of small savers. Let us for the moment forget about the growth-vs-inflation tradeoff and look at the first, direct effect of lower interest rates. That effect is lower income for lenders and lower cost for borrowers. So who is the biggest borrower in the country? Obviously, the Government of India. And who is the biggest lender? The people of India, directly or indirectly.

In terms of savings, India is still very much a fixed-income country, and the tens of crores of people have all their financial savings in bank FDs, PPF, post office deposits and such. Since the flow of money through the banking system amounts to these people lending to the government and to businesses, it's easy to see what lower rates mean for savers. Savers need a real rate of return at least two or three per cent higher than the consumer inflation. When you lower the retail rates from, say 7 per cent to 6.5 percent, 8 percent of their income is gone.

Unfortunately, there is no real, substantive solution to this problem which does not involve equity. That's something that most retirees, with a lifetime of faith in deposits and distrust of equities, are unable to consider. Ideally, even a reasonably conservative hybrid fund, held for a period of three to five years and above, would solve this problem. However, the variability of the value is a psychological barrier that savers of an older generation cannot cope with. I find that younger investors, for example those who have been investing in ELSS funds, get well-used to such variability. They learn the lesson that there may be ups and downs in equity-backed funds but eventually the gains are good. Perhaps this is not a lesson that can be learned later in one's investing life.

However, even if they stick to fixed-income sources, such savers to do well to learn another lesson from mutual funds, which is that tax-efficiency matters a lot. The benefits of using mutual funds funds go beyond just returns. The different taxation structure means there's a bigger difference in post-tax returns. The tax difference arises from the fact that returns from fixed deposits are classified as interest income while mutual fund returns are classified as capital gains. Under interest income, you have to pay tax every year for what you earned that year. If your total interest income from a bank (all accounts and deposits together) exceed Rs 10,000 then the bank also deducts TDS at 10%. In fact, if the bank does not know your PAN, it will deduct 20%. This means that a part of your return is not available for compounding because it is taken out and paid as tax every year.

There is a further advantage to the mutual fund option if you stay invested for more than three years. If you redeem after three years, then the gains are classified as long-term capital gains and are taxed after indexation. Essentially, you get taxed only on inflation adjusted returns. Again, this does not happen with FDs. Applying all these factors, a three-year investment even in shortest-term debt fund will leave you with almost twice the returns as an FD over the same period.

You may want stable returns, but surely you don't want to lose more to taxation than you need to.