Should You Invest in Bank FDs or Liquid Mutual Funds?

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Savings bank account and liquid and ultra short term bond funds were the only options available to investors looking to park their surplus cash in hand. Even after the deregulation of interest rates, mutual fund options were preferred by individuals in the highest tax bracket due to higher post-tax returns. But the scenario has changed a bit lately. The State Bank of India has recently increased the interest rate on fixed deposits of seven to 180 days up to . 15 lakh by 100 basis points to 8%. The interest rate is 9% for deposits between . 15 lakh and . 1 core. More importantly, there is no penalty on premature withdrawal of these deposits. Put simply, you can walk out of the bank with your money anytime after seven days and can still enjoy high interest rates. Obviously, high net worth individuals should take a hard look at these deposits. Ultra short term bond funds are offering annualised returns of around 9%. The post-tax returns offered by the short term fixed deposits or saving bank accounts are lower, which make the ultra short term bond funds still a better parking space for money. Towards the end of March this year, the liquid and ultra short term bond funds category offered weekly average returns of 0.21% and 0.26%, respectively. These translate into double-digit annualised returns. But one must understand that this is an outcome of the extremely tight liquidity condition towards the end of the financial year. Things may change soon.

Short term interest rates are expected to move down gradually as liquidity tightness in the system improves over a period of time. One-year bank certificate of deposit (CD) yield, which was at 10.15% on March 30 this year, eased to 10% by April 12. Over the same period, three-month CD yield came down from 10.70% to 9.75%.

This is in line with the expectations of market pundits. Though many market participants agree on interest rates going down this financial year, few expect a big fall in interest rates in the near term. RBI is expected not to touch CRR and maintain liquidity at the current levels. This should support the short-term rates in the near term The central bank may take time before cutting key interest rates. Given the heavy government borrowing programme in the first half of the financial year, liquidity may not improve drastically, which will ensure that money market rates won't move down much.

If you look at the post-tax returns, the dividend options of ultra short term bond funds look attractive. Dividend distribution tax (DDT) on liquid funds stands at 27.03%, whereas DDT on ultra short term bond funds stands at 13.52% for individual investors. Fixed deposit interest is added to your taxable income and taxed at the marginal rate, which means for the highest tax slab it is 30.9%. The Union Budget 2012 proposes that savings bank interest income up to . 10,000 will not be taxed. A reverse calculation shows that if you have . 2.5 lakh in your saving bank account for one year, you will exhaust that limit at 4% rate of interest. Interest earned from your saving bank account beyond this limit will be taxable at the marginal rate. Though it appears to be a situation of 'advantage mutual funds', when it comes to money parking solution, there is another side of the coin. Before parking your money in a scheme classified as an ultra short-term bond fund, do check if there is any exit load. Some such schemes do have exit loads. If you cannot keep your money for the stipulated period after which there is no exit load, avoid such schemes.

There is one more point you need to look at. A bank has to pay the agreed interest rate at the time of accepting a fixed deposit, even if the market interest rate falls in the currency of the fixed deposit. But a mutual fund performance is linked to market interest rates. The returns will fall if the interest rates were to go down in funds that do not have a significant mark-to-market component. Let's understand this with a simple example. You enter into a 180-day fixed deposit with 8% interest rate, and after one month, the bank revises the interest rate down to 6% in sync with market rate for all future customers. But the bank will pay you interest at 8%. However, things will be different for a mutual fund. Returns in the third month may not be the same as in the first. As the fund manager has to deploy maturity proceeds of high-paying investments at lower interest rates prevailing in the market, the returns should go down.

If you are expecting a massive fall in short-term interest rates, you can consider fixed deposit with no premature withdrawal penalty and lock in your returns. Otherwise, mutual funds should offer better post-tax returns.

 

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