Mahesh is 31 years and works as a lecturer in a top private college. He is well paid and earns Rs 13 Lakhs a year. Mahesh has always invested in FDs and the reason is simple. FDs are safe and offer decent interest. Mahesh stays far away from mutual funds as he believes they invest in stocks making them extremely risky. Is Mahesh Right? Do mutual funds only invest in stocks?
When you say mutual fund, the first thing that come to mind is the Equity Mutual Fund. Mutual funds are not all about stocks. They do invest in fixed income instruments. Let’s take a close look at fixed maturity plans also called FMPs, a type of mutual fund and how they are better than fixed deposits.
FMPs are closed-ended debt funds with a fixed maturity period normally just over 3 years to take advantage of the long term taxation. You can invest in FMPs through a New Fund Offer or NFO. Closed-ended means the FMP has an opening date and a closing date and you must invest within this time. FMPs invest your money in money market instruments like certificates of deposits, commercial paper, corporate bonds, treasury bills among others. They invest in debt instruments and you can check the credit rating before investing.
Mahesh doesn’t like risk in investment. Mahesh asks only this question? Are FMPs safe like FDs? In FDs you already know the maturity value of the invested amount at the time of investment itself, as interest rate is fixed. FMPs offer only indicative yields, but the Yield to Maturity of the portfolio is disclosed regularly. FMPs also invest in safe debt products. Infact, some of them invest into PSU and Bank deposits/bonds only. You can also choose an FMP with a high credit rating. Though the NAV is reported daily and may vary in line with movements in interest rates, if you hold to maturity, the returns are largely fixed.
If you want higher returns than FDs and are willing to bear a slightly higher risk, then invest in FMPs. FMPs are low risk investments compared to equity mutual funds. FMPs are listed on the stock exchange, but liquidity may not be available at all times on the exchange and hence are less liquid than FDs.
Mutual Funds vs FDs
When it comes to taxes, FMPs score over FDs, especially if you fall in the highest tax slab. The interest earned in FDs is added to taxable salary and you are taxed as per your tax bracket. Mahesh falls in the 30% tax bracket and FD interest income is taxed at the highest rate or marginal rate of tax.
In FMPs, taxation depends on the type of fund. Choosing the dividend option means you bear the dividend distribution tax, DDT of 28.84%, which is slightly lesser than the marginal rate of tax on FDs. It’s in the growth option of FMPs where tax is saved.
If you quit the FMP before 36 months, gains called short term capital gains are added to taxable income and taxed asper tax bracket. If you stay invested for 3 years or more, gains are called long term capital gains which attract 20% tax with the indexation benefit. Indexation inflates the purchase price of the FMP, saving tax.
If Mahesh invests Rs 10 Lakhs in FDs of 3 year tenure, the interest earned is taxed at the highest tax rate of 30%. If the FD offers 7% interest, this translates to a post-tax yield of 5%, which isn’t much. Lets say Mahesh invests Rs 10 Lakhs in an FMP of same tenure. FMPs can give returns of around 7.25-7.5% a year, though returns aren’t guaranteed. With the indexation benefit, post tax returns are nearly 1.25-1.75% higher than FDs. This makes FMPs a better investment than FDs on a post tax return basis.
Will Mahesh invest in FMPs over FDs for higher returns? Investing in FDs largely erode your wealth if you consider impact of taxes and inflation. (ie. if you are in the higher tax brackets.) FMPs are quite safe, especially if you chose a fund that invests in quality debt. FMPs are a smarter option, and may just help you beat inflation on a post tax basis. That’s a call that Mahesh can take if liquidity is not a requirement for him.