NRE - FD vs Bond Mutual Fund

Interest rates on NRE - FD’s are on the decline; Interest rate has come down from 9-10% (during FY 2011) to 5.5-6.5% (as of July, 2017). India’s retail Inflation hit a historical low of 1.54% in June and lower inflation level would lead to further cut on the interest rate. NRE-FD rates are most likely to go down further from the current levels. Under these circumstances, an NRI investor would be better off investing in a bond mutual fund rather than NRE-FD.

Return: Bond Fund has potential to generate 2-3% higher return than bank FD

NRE-FD offers fixed return, currently in the range of 5.5%-6.5% (depending on the tenor and size of investment); Bond mutual fund return depends on the interest rate movement and has potential to generate a return of 9-10%. Bond fund can be broadly categorized into short term income funds, long term income funds, floating rate bond funds, gilt funds, and credit opportunities fund. Interest rate movement affect different bond category differently. Investors would be able to generate a 2-3% excess return by appropriate selection of bond fund.

Risk: Bond fund could be a safer bet than Bank FD

RBI’s Deposit Insurance and credit guarantee corporation (DICGC) provides a maximum insurance of Re 1 lac per person per bank  against  all investments such as saving deposit, Recurring and fixed deposit held with the bank. In India, lot of cooperative banks (ex madhavpura mercantile cooperative bank) have failed in the past and depositors have lost money with bankrupt cooperative banks; however as per my knowledge no commercial banks have gone bankrupt, but in future bankruptcy cannot be ruled out with mounting NPA levels and weak credit ratings (lower than AAA) of most commercial banks. While on the other hand, Bond mutual fund provides diversification benefit as fund invests in a portfolio of government bonds and corporate bonds (Generally AAA rating). In my opinion you would be better off investing in bond fund (diversification benefit, better credit rating) than the bank FD (concentration risk, rating depends on bank performance) purely from risk perspective.

Liquidity: NRE FD is illiquid when compared to Bond funds.

Assume Mr X invests in an NRE FD for 5 year period @ 7%; but say at the end of 3.5 years he is in need of money so he decides to redeem his FD, Mr X will lose a lot

·              NRE FD’s pay interest only for the completed year (means Mr X will get the interest for 3 years and loses the interest of the remaining 0.5 years)

·              NRE FD’s pay lower interest of the completed period (assume 3 Yr NRE FD rate was 6.5%) or locked in period (invested @7%)à Mr X will get only 6.5% (as it is lower)

·              NRE RD’s put an prepayment penalty of 0.5-1%

So Mr X would get an interest rate of 5.5%-6% for 3 completed year for the investment redeemed at the end of 3.5 years

While in Bond fund the exit load would generally be in the range of 0.5%-1% if redeemed within 1 year and no exit load for any redemption after 1 year

Flexibility: Bond fund offers more flexibility than bank FD

Bond funds allows Partial withdrawal; lot of fund houses and bond funds to choose from; can create a diversified bond portfolio easily while NRE Bank FD does not allow partial withdrawal, you will be stuck with one or maximum two banks for your NRE FD’s.

Taxation: NRE FD is tax free while bond fund returns (if withdrawn) are taxable

In bond funds, There is no tax on interest income; tax would be levied only on withdrawal/redemption. If Mr X redeems his investment within three year (short term capital gain is applicable, @ applicable tax slab) and if he redeems after three year (long term capital gain is applicable, @ 10%)

Assuming Mr X hardly has any income generated in India; then he would in 0% tax slab, so any redemption within three years would be tax free. And any redemption after three years will fetch 10% on the gain.

Assume NRE FD gives 6% return; Mr X has to generate a pre tax return 6.7% from bond fund (0.67% return would go for tax); so if Mr X deploys in bond fund which can give more than 6.7% he would be better off than investing in NRE FD @ 6%

Conclusion:

 Bond funds are better in terms of after tax return (by 2-3%), liquidity (easy to redeem), flexibility (more options, partial withdrawal facility), lower risk (diversification, better ratings) compared to NRE Bank FD.

Lot of bond funds are available, need to select an appropriate mix depending on market conditions and your investment requirements.

 I advise investors to seriously consider bond fund as an alternative for NRE bank FD, if you would like to be financially better off.

For any investment related queries/advise feel free to get in touch with me; you can reach me on 0965-65708812/91-9500151529

Bank FD vs Bond Mutual Fund: Taxation

Bank FD & Bond Fund both are fixed income securities. The most ignored part while investing in fixed income securities is the effect of taxation. The blog highlights the differences

Tax Effect on Bank FD

Taxes are paid on accrued interest and payable as per the individual tax brackets.

Ex Mr X invest Rs 10 Lac in a bank FD yielding an interest rate of 6%; Mr X is in a 30% tax bracket; then Mr X has to pay an average tax of Rs 18,000/Annum. The effect of tax over 5 year is as shown below

	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Interest Income	60,000	60,000	60,000	60,000	60,000	3,00,000
Tax Effect	Income	Income	Income	Income	Income
Tax Payable rate	30%	30%	30%	30%	30%
Tax Payable	(18,000)	(18,000)	(18,000)	(18,000)	(18,000)	(90,000)
After Tax Interest Income	42,000	42,000	42,000	42,000	42,000	2,10,000

Tax Effect on Bond Mutual Fund:

Taxes are paid only on redemption/withdrawal and the rates depend on the nature of gain. For Bond fund any redemption within three years is considered as short term capital gain (taxed at applicable individual tax bracket) and redemption after 3 years is considered as long term capital gain (taxed at 20% adjusted for indexation benefit- works out close to 10%)

Ex Mr X invest Rs 10 Lac in a bond mutual fund and decides to withdraw 6% income on yearly basis (to match Bank FD Cash flow) ; Mr X falls in a 30% tax bracket; then Mr X has to pay an average tax of Rs 1,730/Annum. (91% lower than bank FD)

	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Withdrawal	60,000	60,000	60,000	60,000	60,000	3,00,000
Capital Gain (at 6% return)	3,396	6,600	9,623	12,474	15,165
Tax Effect	STCG	STCG	STCG	LTCG	LTCG
Tax Payable rate	30%	30%	30%	10%	10%
Tax Payable	(1,020)	(1,980)	(2,887)	(1,247)	(1,516)	(8,650)
After Tax Interest Income	58,980	58,020	57,113	58,753	58,484	2,91,350

 *STCG-Short term capital gain; LTCG- Long term capital gain

Conclusion: Bond Mutual fund taxes are applicable only on redemption while on bank FD’s taxes are applicable on accrued interest; Bank FD taxes would be 10 times higher than that of bond mutual fund. Bond Mutual fund provides higher return, offers better liquidity and most efficient in terms of taxes compared to Bank FD.

Bond/Debt Mutual Fund: An Overview

Bond/Debt mutual funds are funds that invest in instruments such as Treasury bill & Treasury bond (issued by Government), Certificate of Deposit (issued by Banks), and Commercial Paper & Bonds (issued by corporate).

Categories of Debt Mutual fund

Category	Suitable for
Liquid fund Money Market funds Ultra Short term fund	Invest primarily in short term securities like certificate of deposit, Commercial paper, Treasury bill. Weighted average maturity of the fund would be less than 1 year. Often used as alternative to a savings bank account and can be used to park one’s surplus cash.
Short term Fund Medium term fund	Invest primarily in corporate bonds with tenor (maturity) of 1-5 years. Often used to generate return better than an comparable Bank FD and suitable for investors with investment Horizon of 1-5 year period
Long term Fund Income fund	Invest primarily in corporate bonds with tenor (maturity) greater than 5 years. Often used to generate return better than an comparable Bank FD and suitable for investors with longer investment horizon
Gilt funds	Invest primarily in Government securities; Gilt funds can be again classified as short term gilt fund (tenor less than 5 Years) and long term gilt fund (tenor greater than 5 year). Gilt fund have minimal credit risk but would be exposed to interest risk

Bank FD vs Bond/Debt Mutual Fund

Particulars	Bank Fixed Deposit	Bond/Debt Mutual Fund
Return	Fixed	Variable
Potential Return (>1 Year)	7-8%	9-10%
Maturity Period	Fixed period	·         Open ended schemes allows to redeem anytime ·         Closed ended schemes have fixed maturity
Pre closure	Pre closure penalty of 0.5-2%	·         Exit load might be applicable if exited within 1 year and can range from 0.5-1% for Medium/long term bonds. ·         No load when held for more than 1 year for medium/long term bonds ·         No load on liquid/ultra  short term bonds regardless of holding period
Partial withdrawal	Not allowed	allowed
Taxable	Yes	Yes
Taxable Impact	High	Low
Tax efficiency	Low	High

Conclusion: Bond/Debt Mutual Fund provides better return than equivalent bank FD with marginally higher risk; Bond/Debt Mutual fund provides lot of flexibility when it comes to liquidity and more tax efficient compared to a bank FD. So would advise to seriously consider Debt Mutual fund as an alternative to Bank FD.

For any investment related queries feel free to get in touch on 0965-65708812