Yehi hai wrong choice | Value Research India may be a ‘fixed income country’, but why does it have to be the wrong choice of fixed income investments?
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Yehi hai wrong choice

India may be a 'fixed income country', but why does it have to be the wrong choice of fixed income investments?

Yehi hai wrong choice

Putting all (or almost all) of your savings in fixed income deposits is a sin that's second only to not saving, or not saving enough and almost every Indian saver is a sinner too. For many years now, one topic that I have written about repeatedly is the superiority of fixed-income mutual funds over bank fixed deposits. It's not an exciting topic so it's natural that savers don't have too much interest in the topic.

However, we must make the best of a bad situation. India has always been a 'fixed income country'. Generations of savers turn automatically to savings instruments like PPF, bank deposits, post office deposits, etc., for all their savings needs. The fact that this is not a great choice is a separate story but even within the fixed-income space, most of us fail to think through things, and make the worst possible choices.

On the face of it, the difference between the best and the worst fixed-income choices is perhaps 1.5 to 2 per cent. That sounds trivial but over time this makes a big difference. Across a couple of decades, a differential of 2 per cent a year will add up to a differential of more than 50 per cent in the amount you gain. Now you might think that no one invests for 20 years but that's not at all true. While a given investment may not last for more than two or three years, most savers always have a substantial amount invested in fixed income options for decades. So this kind of a lost opportunity is a common event, and happens to almost every saver.

Here's what we almost never realise: the best way to maximise your real, post-tax fixed income gains is to switch from deposits to fixed-income mutual funds. Despite the turmoil in certain types of debt funds, the shortest-duration debt funds are the safest and offer substantial advantages over fixed deposits. Unlike bank FDs, open-end fixed income fund investments can be redeemed at a day's notice without any compromise on returns and investors can start the investment without having to decide what period they are investing for. And, on top of that, over time the funds generally manage to deliver 1 per cent higher returns than fixed deposits. Even with the same tax level, the cumulative effect of these small advantages make them a compelling choice.

Still, the biggest kicker is the tax difference. One reason is lower tax, and the other is TDS. The source of these advantages is that the returns from mutual funds are seen under the tax laws as capital gains. In contrast, the interest earned on deposits is income and is just added to taxable income. Capital gains is taxed when you actually redeem the investment while income is taxed continuously. You have to pay tax every year for the interest you earned that year, just like any income, regardless of whether you have encashed it, or it is still compounding with the deposit. The bank will deduct TDS on this income. If your total interest income from a bank (all accounts and deposits together) exceeds Rs 10,000, then the bank deducts TDS at 10 per cent. This means that a part of your return is not available for compounding because it is taken out and paid as tax every year. This has a big impact on the eventual returns.

But wait, that's not all! If you stay invested for more than three years, then the capital gains are classified as long-term capital gains and are taxed only after inflation indexation. This does not happen with FDs because the interest is just normal income. Taking into account all these differences, in practice, a three-year investment even in a very short-duration debt fund will mean around double the actual post-tax returns compared to the options.

It's a tragedy that most Indian savers, despite being heavily dependent on fixed income investments, don't try to get the best out of them.

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