Best alternative to FDs amidst rising interest rates
The Central Bank of India increased interest rates from 4% at the beginning of 2022 to 6.25% at the conclusion of 2022. The purpose of the central bank’s abrupt hike in interest rates during this brief period was to contain inflation and prevent the economy from overheating in the face of uncertain global economic conditions.
Along with repo rates, fixed deposit rates increased too albeit not as much as policy rates. In this scenario, as an individual investor, the proposition of parking your money in a fixed deposit may appeal to you because it is a safe, assured, and stable investment.
However, there is another investment tool that may offer a better prospect of returns.
Such an opportunity exists with Targeted Maturity funds.
What are Target Maturity Funds?
Targeted Maturity Funds (TMFs) are passively managed debt funds which track an underlying bond index. Instead of buying a single bond, the asset management company (AMC) invests in a collection of bonds thus helping in diversification. These funds have a defined maturity. By buying a target maturity fund, an investor locks in an interest rate and benefits from it despite any deterioration in the broader economy but only if it is held till maturity. Target maturity funds are liquid, there is no lock-in and these are open-ended funds. Though they do not have a lock-in period, investors are recommended to follow Buy and Hold (to maturity) strategy to get maximum benefit.
As TMFs are passively managed funds, the expense ratio is very low, usually ranging from 10 to 50 basis points. The bonds in the index that TMF tracks pay regular interest (coupons). The coupons paid by the bonds are re-invested in the fund and benefit from compounding. On the maturity date, investors get the principal amount along with accrued interests.
Examples of Targeted Maturity Funds in India:
|1||Edelweiss Mutual Fund BHARAT Bond ETF – April 2025 – Growth Fund||NIFTY Bharat Bond Index Series – April 2025|
|2||IDFC CRISIL Gilt 2027 Index Fund||Crisil Gilt 2027 Index|
|3||Edelweiss Mutual Fund BHARAT Bond ETF – April 2030 – Growth||NIFTY Bharat Bond Index Series – April 2030|
|4||DSP CRISIL SDL Plus G-Sec Apr 2033 50:50 Index Fund – Direct Plan||CRISIL SDL Plus G-Sec Apr 2033 50:50|
Target maturity funds give better post tax returns when compared to fixed deposits. Below is a detailed comparison of both these financial instruments.
Fixed Deposits vs Targeted Maturity Funds
|Parameters||Targeted Maturity Funds||Fixed Deposits|
|Credit Risk||TMFs invest in a basket of fixed-income securities such as Government Securities (G-Secs), State Development Loans (SDLs), and PSU bonds. Thus, credit quality is fairly high but it is riskier than FDs.||Guaranteed returns and is immune to market fluctuations making it one of the safest investment options.|
|Tenure||Defined maturity dates. Investors can choose from maturity of 1, 3, 5, 7, 10, and 15 years.||Investment tenure can range from 7 days to 10 years.|
|Liquidity||Like equity stocks, one can sell/redeem units of target maturity ETFs at any time on stock exchanges or in the case of index funds with AMCs..||Pre defined maturity date, and early withdrawal may result in a penalty.|
|Returns||Predictable returns if held till maturity.||Guaranteed returns for the entire term of the deposit.|
|Taxation||Short term capital gain tax (less than 3 years) at individual’s applicable tax slab.|
Long term capital gain tax (greater than 3 years) at 20% post-indexation i.e. only gains over and above inflation will be eligible for taxation.
|Interest earned on fixed deposits is added to the investor’s income and is taxed as per the tax slab.|
Let us compare the returns earned from both the instruments with an example to clearly depict the benefit of investing in a TMF.
Your goal is to pay for your child’s education in 7 years, you can invest in the Edelweiss BHARAT Bond ETF – April 2030 that invests in constituents of the Nifty BHARAT Bond Index – April 2030. The index shall mature on 15 April 2030. Alternatively you can invest in an HDFC Fixed deposit for 7 years
|BHARAT Bond ETF – April 2030||Bank FD|
|Amount in Rs. (A)||1,00,000.0||1,00,000.0|
|Rate p.a. ( R )||7.56%||7.00%|
|Tenure in years (T)||7||7|
|I||Investment Amount after 7 years (1+R)^T*A||1,66,554.2||1,60,578.2|
|II||Initial investment amount after 7 years (1+INF)^T*A||(With indexation Benefit)||(Without Indexation Benefit)|
|Adjusted invested amount||1,40,710.0||1,00,000.0|
|III||Capital Gains (I – II)||25,844.1||60,578.2|
|V||Tax Amount (III * IV)||5,168.8||18,173.4|
|Amount Received at Maturity (I – V)||1,61,385.4||1,42,404.7|
|Post Tax Annualised Return||7.08%||5.18%|
1. The YTM of the Nifty BHARAT Bond Index – April 2030 is 7.56% as on 12th January, 2023.
2. HDFC Bank FD rates for 5-10 years as on 10/01/23 is 7% p.a.
3. Inflation target set by the RBI is from 2%-6%. We have assumed annual inflation rate of 5%.
4. We assume the income tax rate to be 30%.
Here, we can see post tax return is better for the targeted maturity fund for this particular tenure. But, returns would be similar to FDs if we look at a shorter investment horizon without the indexation benefits.
Fixed deposits are only recommended to investors who prefer to sit outside the ambit of Indian capital markets. Otherwise, a fixed deposit is the most tax-inefficient instrument for an investor, especially one in the 30% tax bracket.
The interest income from a fixed deposit is added to the annual income. So if a person falls in the 30% tax bracket, the interest income from a fixed deposit scheme will be taxed at a whopping 30%. Therefore, it remains best to avoid fixed deposits.
Thus, investments should be catered to your financial goals. Please also note that this example is for illustration purposes only and actual returns will vary from case to case basis.
When should you invest in TMF?
TMFs are suitable investment instruments for goal based investing i.e. your investment horizon matches with the maturity of the fund.
TMF especially becomes an attractive investment instrument during high-interest rates in the economy as it allows you to lock in current rates which will be received over the maturity period even if interest rates decrease in the future.
Fixed Income schemes like Targeted Maturity Funds might not have the same buzz as public equity investments, but a prudent investor with a medium to long-term investment horizon can judiciously utilize TMF to earn consistent returns with fairly lower volatility.
Staying ahead of inflation doesn’t always mean buying only the equity-oriented instruments as there is sufficient evidence of the past that denotes sub-par or flat returns in equity instruments as well.
The optimal way to go forward is to have the right asset allocation model as per the risk appetite and goals of an investor. One can build an optimum portfolio by investing across asset classes like equity, debt, gold etc. based upon his/her financial goals.
Disclaimer: Above piece is only for information purposes. Please consult a SEBI Registered Investment advisor before taking any investment decision.
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Interesting article. Comes at the right time, as I’m looking to create a fund for my son’s education.
Couple of observations/questions:
1. Post indexation and post tax returns of 7% means inflation adjusted returns are just about 1-2% right?
2. Are NBFC FDs better than TMFs? Bajaj Finance is offering over 8% at present. Do they offer indexation benefit and what is the tax rate?
3. Also, 5-year FDs offer tax deduction under 80C. So that may offset the lack of indexation.