Fund Talk

I am a regular reader of your articles. My queries today are regarding debt/balanced funds.

* Are debt and balanced funds a more tax efficient alternative to bank deposits? If so, under what conditions?

* How do we compare different debt/balanced funds and Monthly Income Plans to select the right one?

* I want to accumulate about Rs 10 lakh over a four-year time frame towards down payment for a house. I can invest about Rs 20,000 per month. The question is whether I should invest through bank deposits, debt oriented funds like MIPs or Balanced funds to reach this target? Of course, I understand that mutual funds carry more risk compared to bank instruments. Can you please suggest some debt oriented funds (liquid, MIP, Balanced or other categories)?

K.Giri

Debt and balanced funds are subject to differing tax treatment and yes, in certain circumstances they can be more tax-efficient than bank deposits. The interest income that you earn from a bank deposit is added to your annual income and taxed under the slab rate applicable to you, which can range anywhere between 10 and 30 per cent.

For balanced funds which invest over 65 per cent of their portfolio in equity instruments, dividends distributed are completely tax free in the investor's hands. Capital gains on such funds' NAV are taxed at 15 per cent as short term gains, if the fund is held for less than one year. Gains are tax-free if held for more than one year.

Debt fund implications

As for debt oriented funds, the dividends paid out by the fund are subject to a dividend distribution tax at 12.5 per cent at the fund's end. For the current year, capital gains realised on such funds within a year are subject to tax at your slab rate and long term capital gains, realised after holding units for 1 year are subject to long term capital gains tax at a flat 10 per cent (or 20 per cent with indexation). The net implications of all this for you as an investor are that:

* Balanced funds are the most tax efficient for all categories of investors compared to debt funds or bank deposits (they however carry higher risk).

* If held for less than a year, capital gains on debt oriented mutual funds suffer the same tax as your slab rate currently. For investors in the 20/30 per cent brackets, holding debt fund ‘dividend options' would entail lower tax.

* If held for over a year, debt funds are a more tax efficient option for investors in the 20 & 30 per cent brackets, whether held through dividend or growth options.

Safety and liquidity

The key points of difference between debt mutual funds and bank deposits are on safety and liquidity. Bank deposits, especially given that deposits up to Rs 1 lakh are insured and that returns are fixed are far safer than debt mutual funds which will see their returns move in tandem with prevailing market conditions for debt instruments.

Investors in debt funds assume two kinds of risk- credit risk on the instruments held by the fund and interest rate risk – changes in interest rates impacting the fund's NAV. These risks are however fairly low for short term debt funds and liquid funds compared to long term income or gilt funds.

The factors that prospective investors need to consider while choosing debt funds are: Return track record of the fund over 5.3 and 1 years, credit and maturity profile of the portfolio, size of the fund, pedigree of the fund house and record of the manager.

Investing Rs 20,000 a month over a four-year period at an 8 per cent rate of return would lead you to a corpus of Rs 11.3 lakh. However, as a monthly investment format is only permitted by mutual funds (recurring deposits with banks may not consistently offer 8 per cent over the next four years), you may need to split your monthly investment to invest Rs 15,000 a month in a short-term debt fund (Templeton India Short Term Income or Kotak Floater Long Term and HDFC Floater Long Term) and Rs 5,000 a month in a balanced fund (HDFC Prudence or DSP Balanced).

We assume these investments will yield 7 per cent and 12 per cent per annum respectively. After reckoning tax incidence, this may translate into an effective return of 7.7 per cent for your asset mix. Given your short horizon, though, you may need to track your portfolio regularly and switch funds if they underperform.

Queries may be e-mailed to >mf@thehindu.co.in , or sent by post to Business Line, 859- 860, Anna Salai, Chennai 600002.

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