High returns and High Safety

“9.75% interest rates ” screamed the hoarding outside a prominent bank near the stock exchange . Bank interest rates are now looking attractive and it may be a good time to lock in debt allocations at high rates of interest . However before locking in your hard earned money in 'safe' bank Fds you must consider some facts.

Taxes- Bank interest in fully taxable in your hands . Depending on the highest income bracket in which you fall , you may pay upto 30 % taxes on interest income . Effectively this means that a person falling in the 30% tax bracket will earn only 6.8% (9.75% less 30% taxes ) returns after paying taxes

Inflation adjusted returns – Let me explain this with a simple example .Say you are able to buy your days requirement of vegetables for Rs.20 today . Assume prices of vegetable go up next year by 10 % while you have invested Rs.20 in a FD earning 8% . We also assume that you fall in the lowest tax bracket of 10 %. In a years time your Rs.20 would have grown to Rs. 21.5 after taxes . Not enough to buy your requirement of vegetables as this will cost you Rs.22( due to 10% inflation )! . The purchasing power of your Rs.20 has fallen and in simple words that means you are poorer than you started -despite saving money and having 'protected ' capital .You have to calculate post inflation returns to see if  you are losing or making  money while investing in FDs

Liquidity – When you break a FD , the penalty for earlier withdrawal is not the only cost . You also end up earning a very low rate of interest ( applicable for the period of holding ). Lets take an example of Fd rates at the time of your investment

3 months to 6 months -6.5%

6months to 9 months -7.5%

9 months to 2 years -8.755

If you invested in a 1 year Fd @ 8.75% , but required money before the end of six months ,you would end up with 6.5% rate of interest and not 8.75%. Besides when a withdrawal penalty is applicable, it would mean further reduction in returns .

If you pay taxes , or are unsure of you liquidity needs , short term bond funds are a great way to invest safely with tax efficient returns . These funds invest in quality bonds /papers issued by corporates , Cds ( deposits) of banks and in Government bonds . Their investments in high quailty instruments ensures a high degree of safety .Yes ,unlike banks they don't guarantee a fixed rate , but a good financial advisor can easily tell you the range of expected post tax returns . If you are investing for periods less than 1 year the Dividend option is best taken , as dividends are tax free. For periods over 1year , Growth option can be considered . Long Term Capital gains on bond funds are taxed at 10 % or at 20 % with indexation benefit .If you get double indexation benefits then capital gain tax on debt schemes can go to practically zero . You must compare post tax returns from bank Fds with Fixed Maturity Plans or open ended bond funds for a apple to apple comparison .

Most short term schemes have very nominal exit loads and that too for very short periods of time ( 3 months to six months ) after which they can be withdrawn as and when needed. The best part of these schemes is that you get market linked rates , which means that ,unlike bank Fds, whether you invest for three or six or ten months the interest rate will not change dramatically .

In the end , it is important to remember that debt investments can only be made for parking short term fund requirements or as a part of an asset allocation plan . Unlike equities or real estate they cannot be used as a tool for long term wealth management.