Are debt funds an alternative to small savings schemes?

Kavya Balaji   /   January 4, 2021
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The government has been cutting the interest rate on many of its small savings schemes including the popular Public Provident Fund (PPF). This is because of the change in the way interest rates are set for small savings schemes. Earlier, interest rates were set for a full year. Now, they are reset every quarter based on changes in the yields of government securities. So, if the rates have been reset on April 1st, the next change in interest rates will come on July 1st. 

Why are interest rates being cut? 

The interest rates in the country and the yields of government securities have been falling. The yield on the 10-year benchmark Government security is down to 5.9% from 6.5% a year ago. Given the steep fall in a short time, small saving schemes which are linked to government securities are providing lower returns. PPF and Senior Citizens Savings Scheme (SCSS) are the ones that provide higher returns. While PPF interest rate is 7.1%, the interest rate of SCSS is 7.4%.

Why debt funds

In the past year, debt funds have given better returns than small savings schemes. While the average return from long duration debt funds was 14%, short and medium duration debt funds have provided investors with returns of 9%. Funds such as ultra-short-term funds have provided returns that are better than that of post office savings accounts.

Another important point is that the taxation of debt funds is more beneficial than that of savings schemes. Returns you get from post office deposits are taxed as per your tax bracket. For debt funds that have been held for more than three years, the gains are considered to be long term capital gains (LTCG). They are taxed at 20% with indexation benefit. This benefit allows you to recalculate the purchase price after adjusting it to reflect the effect of inflation. This reduces the overall tax on your capital gains. 

Another favourable point for debt funds is that they have higher liquidity when compared to post office savings schemes. They don’t have any lock-in such as those for PPF. You can withdraw from debt funds anytime you want. Some debt funds don’t even have any exit load. So, it will not cost you to withdraw money from debt funds.

Here’s how debt funds compare to some of the post office savings schemes.

Ultra-Short-term funds Vs. post office savings account

Interest for post office savings account is only 4% while Ultra short-term funds have provided investors with returns of more than 5%. These funds invest predominantly in securities that have very short maturities. This includes money market securities and government treasury bills. So, you don’t need to worry about credit risk if you invest in these funds. There are fund houses that allow you to withdraw your money almost instantly from some of the funds. This gives you the convenience of a savings account. 

Medium to long duration funds Vs. post office time deposits

Medium duration funds are comparable to bank fixed deposits. Investors choose these funds when their intention is to lock in their investments for a fixed tenure of more than a year. These funds provide higher interest than any of the post office time deposits. Most time deposits provide just 5.5% while medium to long duration funds have given 11% in the past year. Medium duration funds even score over time deposits on the taxation part. Interest on deposits is fully taxable. However, if you invest in medium duration funds for more than three years, you can make use of 20% taxation with indexation benefits.

Long term debt funds vs. PPF

Now that the PPF rate is reset every quarter and interest rates are falling, you can choose long duration debt funds to get higher returns. You can benefit from the lower interest rates because when interest rates fall, bond prices will go up helping long duration debt funds to provide higher returns to investors. Long duration debt funds have given 14% in the past year when compared to the PPF interest rate of 7.1%. 

Risk factor

However, when choosing the debt funds to replace your small savings investments, you need to be mindful of the risk you take. Debt funds invest in debt securities of varying tenures and maturities based on the particular fund’s strategy. So make sure you invest in funds with maximum exposure to AAA rated bonds and government securities. Stick to large AMCs who can take liquidity shocks (like Covid 19 related economic crisis). Always look at the underlying securities and see if the fund has exposure to any questionable corporate bonds. Larger exposure to government securities and treasury bills make the fund safer.  

However, debt funds score over post office savings investments on many counts – such as returns, lock-in, cost of withdrawal and taxation. 

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