Debt is also referred as Fixed income investments, as the returns from these investments are known in advance and does not change based on market conditions. The maturity value is fixed. Popular conventional debt options include Fixed deposits(FD), Recurring deposits(RD), post office schemes, Public Provident Fund (PPF), Tax free bonds, etc. The returns from these investments are generally in line with inflation, a few basis points above or below. The below articles would be useful to understand the link between inflation and interest rates to some extent.
How does inflation affect your investment?
Is there a connection between bank interest rates and inflation rates?
Why do FD rate cuts fluctuate
Debt is generally perceived as less risk and suggested for shorter and medium term goals ranging from a few days to a few years. However, it is important to understand that debt instruments have lower capacity to fight inflation especially for investors in high tax bracket. Inflation is the biggest destroyer of purchasing power. Over FY79-15 CPI inflation has been 8.02%, eroding purchasing power of Rupee by 94%.
Source: Bloomberg, MOAMC Internal Analysis. Data as on Nov 30, 2015
Investing may be defined as the process of gaining higher purchasing power over time (i.e. net of inflation and taxes). In fixed income investing, the average annual post-tax return works out to about 7%. If the same is reinvested, over 20 years, the security would be worth about 4x its original value. Hypothetically, if inflation also turns out to be 7%, then even after 20 years, there is zero increase in purchasing power.
On the taxation front, as per current tax laws, long term gains from mutual fund debt is eligible for indexation if held for three years and above. In simple words, indexation spares the gains to the extent of inflation. You pay tax only for the gains in excess of inflation. The below articles could be useful to understand indexation and how it benefits the investor.
No tax deduction at source | Indexation | Set off provision
Another tax-friendly feature of debt funds is that there is no tax deduction at source (TDS) on the gains as of now for resident individuals.
In case of bank fixed deposits, if your interest income exceeds the stipulated amount which is currently Rs 10,000 a year, the bank will deduct applicable TDS from this income. If you are not liable to pay tax, you will have to submit either Form 15H or 15G as applicable to avoid TDS. It is to be noted that the income from fixed deposits is taxed on an annual basis, irrespective of the tenure of the deposit. You will get the money once the deposit matures, but the income is taxed every year.
In debt funds, the tax is deferred till the investor redeems his units. Also, the gains from a debt fund can be set off against short-term and long-term capital losses you may have suffered in other investments. If the debt fund is redeemed within three years, the gains will be added to the person’s income and taxed as per the applicable income tax slab. However, if the investor can hold for more than three years, a debt fund will be far more tax-efficient than a fixed deposit. In a fixed deposit, the entire interest earned is taxed at the rate applicable to the investor. The long-term capital gains from debt funds are taxed at 20% after indexation. Indexation takes into account inflation during the period that the investment is held by investor and accordingly adjusts the buying price. This can lower the capital gains tax significantly.
How to Calculate Capital Gains and What is Indexation ?
This kind of return is more suitable for deriving near-term regular income. But if you want to grow your wealth, this is not enough.
Download this Sample Indexation Calculator to understand indexation yourself
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.