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FMPs still good despite increase in long term capital gains tax
The government recently hiked the long-term capital gains tax rate on debt funds, from 10% to 20%. Additionally, to qualify for long-term capital gains, the term horizon was increased from one to three years. This means investors have to stay invested for a period of at least three years to avail long-term benefits.
Seemingly, these changes in regulation threaten to bring investing in debt funds on a par with bank fixed deposits.
Let's see if this assumption about debt funds is true. In the past few years, bank fixed deposit rates had risen considerably with the current rate at the higher end at around 9%.This was a result of multiple interest rate hikes over the last few years. However, this is likely to reverse as and when the RBI decides to cut interest rates to spur economic growth.
The benefits of investing in debt funds becomes clear by retaining 20% indexation on long-term capital gains. From a layman's point of view, three-year FDs may seem better, but when indexation comes into play for debt funds, the game changes. Indexation reduces the overall tax liability of an individual, thereby resulting in better returns as compared to Bank FDs.
The table gives a comparison between 3-year FDs and 3-year FMPs with 7% rate of inflation throughout the investment period.
At a notional level, FDs seem superior. But FMPs are significantly better the moment indexation comes into play. The only real roadblock, in the aftermath of this regulation, is that you need to stay invested for three years to avail of indexation benefits instead of one year earlier. If you are an investor with a long term horizon, FMPs are still as relevant and as tax efficient as they were the day before the Budget was announcement.
Interest rates in India are at multi-year highs. The recent fall in the crude oil prices and strong domestic economic indicators have significantly improved India's current account deficit (CAD), which in turn has helped reduce consumer inflation (CPI) to 5.52% in October. Going forward, interest rates are likely to decline in 2015 and yields on fixed income securities have already started coming down from recent highs. This is a good time to invest in duration funds like Gilt and long-term bond funds with average maturity of 3-5 years or higher. Such funds have maximum exposure to government securities and are aggressive in nature. Longer the duration, higher would be mark to market returns.
Investors with tax slab of 20% or more will benefit from indexation as well as higher capital gains. Given the interest rate scenario, duration funds are the funds where your money should be. However, if you are conservative and don't like volatility, go for accrual based income funds. These funds invest in corporate bonds and money market instruments like treasury bills, bank certificates of deposit and commercial papers. The average maturity of papers is 2-3 years. The fund manager delivers returns close to yield to maturity (YTM) or coupon rate mentioned at the time of investing. As interest rates are expected to decline, FDs should be completely avoided. One could calculate and see that even at the current interest rate of 9%, FDs deliver post tax returns of 6.21% and 7.2% for 30% and 20% tax brackets, respectively.
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