InvestorQ : Can you quickly give me some debt market options that can give me better returns than traditional Bank FDs?
Arti Chavan made post

Can you quickly give me some debt market options that can give me better returns than traditional Bank FDs?

2 years ago

Bank fixed deposits have been the preferred choice of Indian investors for many years. Apart from the security that banks offered, there was always the added benefit of liquidity in an emergency. An FD could be always be liquidated or leveraged at very short notice. However there are two challenges. Firstly, with the RBI cutting interest rates, FDs are now yielding just about 7% for the full year. Secondly, FDs are not tax efficient as the interest on FDs is taxed at the peak rate of 30%.

Here are options that investors can look at as an alternative to the traditional bank FD…

Take a serious look at Company Fixed Deposits

Most of the large business groups and even NBFCs are continuously raising funds through the FD route. Corporate FDs pay interest rates that are 1-2% higher than bank FDs. The actual rate paid by these companies will depend on the credit rating assigned to them. Normally, higher the credit rating, lower the interest paid. But even the highest rated company fixed deposit will pay an interesting rate that is higher than bank FDs. Of course, one needs to remember that company FDs are unsecured and hence you do not have the security of a bank backing the FD. Tax treatment of company FDs is the same as bank FDs. One can look at company FDs if they want to earn that slightly higher return, but it is always advisable to stick to the reputed marquee names of corporate India.

Tax Free Infrastructure Bonds

The government offers special tax incentives for certain institutions that raise funds via bonds for funding the infrastructure of the economy. Typically, institutions like REC, NHAI, IRFC, IREDA etc are permitted to issue tax-free bonds to fund their massive infrastructure investment plans. The beauty of these instruments is that the interest paid out on these bonds is entirely tax-free in the hands of the investor. These tax-free bonds typically pay nominal interest of around 6.5%, which is lower than a bank FD. However, due to interest being tax-free, the effective rate is higher. Here is how! An infrastructure bond that pays 6.5% will have an effective return of 9.3% {6.5/(1-0.3)}, as it is tax-free. Thus, in post-tax terms it is substantially more attractive than a bank FDs. The only issue in a tax-free bond will be the longer lock-in, but that is small price to pay for a higher effective yield.

Debt Mutual Funds

Debt mutual funds, as the name suggests, are the funds that invest your money in debt instruments. They invest in government debt and in private corporate bonds for the sake of a higher yield. On an average, debt funds give 1.5-2% higher returns on a long term basis compared to bank FDs. But the real benefit may be something different. Firstly, in a falling interest rate scenario, debt funds get the additional benefit of capital appreciation since government bonds move inversely with interest rates. This is a benefit that is not available in bank FDs. Secondly, debt mutual funds are also more tax efficient compared to bank FDs. The interest on bank FDs is taxed at the peak rate (as we saw earlier), but dividends paid out by debt funds are tax-free in the hands of the investor. There are 2 things investors need to remember about debt funds. The debt fund has to pay withholding tax on dividends paid out and that reduces the amount paid out to investors. Additionally, capital gains on debt funds are taxable and hence it may be more efficient to opt for a dividend plan of a debt fund rather than a growth plan.

Fixed Maturity Plans (FMPs)

FMPs are exactly like debt funds in that they also invest in debt instruments. The only difference is that FMPs are closed-ended and for a fixed term to maturity. Hence the fund manager of the FMP will hold bonds and other debt instruments that exactly match with the maturity profile of the FMP. As a result, the FMP almost becomes like an assured return scheme. The returns of an FMP are about 100-150 basis points higher than that of bank FDs, hence investors looking for slightly higher yield can opt for FMPs. There is a word of caution. If you have payout commitments, ensure that your FMP tenure exactly matches with your need. That is crucial!