Investing In A Falling Interest Rate Scenario

T Shrikanth Bhagavat
Managing Director
Hexagon Capital Advisors

I want to make an investment worth Rs 10 lakh and expect returns by December 2015. My bank is currently offering me a fixed deposit account at an interest rate of 8.75 per cent. Kindly advise me with respect to how I can earn higher returns and save tax. My current tax slab is 30 per cent. – Parjanya Mujumdar

In the current scenario, you may be better off investing in debt mutual funds as they have the potential to generate higher returns and are more tax-efficient than fixed deposits. 

You could invest in a mix of short and medium-term debt funds. These usually invest in a variety of investment-grade debt instruments including commercial papers, certificates of deposits, corporate bonds, and government securities. These funds have several advantages over fixed deposits.

The funds shown in the table here are some of the best performers in their categories and have generated double-digit returns over the last year. 

On an average, a portfolio of short and medium-term funds will have a yield of about 9.5 per cent (before expenses). This is higher than the fixed deposit rate currently offered by your bank.

Your portfolio should be geared towards short-term funds such as Birla Sun Life Dynamic Bond Fund and Templeton Short-Term Income Fund. The former is an actively managed open-ended scheme which aims to generate returns and capital appreciation through investments in bonds and government securities. In May 2013, the fund’s modified duration was 2.81 years and the yield to maturity was 8.62 per cent. Generally, the fund does not invest more than 25 per cent of its portfolio in government securities.

The Templeton Short-Term Income Fund aims to provide stable returns through investments in fixed income securities. The fund is accrual-focused and generally invests in corporate bonds at the shorter end of the curve. It had a modified duration of 2.19 years and a yield to maturity of 9.93 per cent in May 2013.

You could also enhance your returns by investing a portion of your corpus in medium-term funds such as Templeton Corporate Bond Opportunities Fund. It aims to generate income and capital appreciation through investments in corporate debt. The fund manager focuses on high-yielding corporate bonds at the medium to long end of the curve. In May this year, the fund’s modified duration was 2.27 years and the yield to maturity was 9.86 per cent. The fund has a 30-month exit load so you may be penalised if you redeem your investments before December 2015.

You could split your investment equally between these three funds to benefit from higher returns and restrict volatility. 
Debt funds may be more tax-efficient than fixed deposits, as you fall in the highest tax bracket. If you invest in a fixed deposit, then your investment will be taxed at 30 per cent. If you invest in the Growth Options of Birla Dynamic Bond Fund, Templeton Short-Term Income Fund and Templeton Corporate Bond Opportunities Fund, you will incur only long-term capital gains tax. You can choose to pay the lower of:

- 10 per cent without indexation or
- 20 per cent with indexation 

Note: You may need to pay surcharge and cess.

As the average expense ratio of the funds is above 1.5 per cent, your proposed allocation may generate a post-expense yield of about eight per cent. Assuming that long-term capital gains are taxed at 10 per cent without indexation, your post-tax yield may be around 7.2 per cent. In contrast, if you choose to invest in a fixed deposit, the post-tax yield on your investment will only be about 6.125 per cent (8.75 per cent less tax of 30 per cent). 

The maximum return an investor can earn from a fixed deposit is limited to the interest rate offered. Hence, your post-tax return from a fixed deposit is unlikely to exceed 6.125 per cent. However, even after expenses, debt funds may generate higher post-tax returns than fixed deposits as these funds usually generate capital appreciation when interest rates fall. 
In conclusion, by investing in short-term and medium-term debt funds, you can benefit from higher post-tax returns and save taxes. You may also benefit from capital appreciation in a falling interest rate scenario.