Fixed Deposits or Debt Funds? How a Pandemic Changed the Equation
I am an eternal pessimist and a staunch believer in Murphy’s law. That is why I have turned myself into an idiot, knowingly, in order to protect my capital from any fallout of coronavirus (COVID-19) pandemic.
 
Let me explain the idiocy part first. The pessimism part will follow.
 
As recently as February this year, while lecturing to a group of bankers, I had made the statement “Anyone who puts money in a bank fixed deposit (FD) is an idiot.”
 
The reason for this apparent slur on the zillions of people who hold bank FDs is, the Indian income-tax (I-T) law. 
 
For decades, Indians have been putting their savings into bank FDs, partly for safety and partly for a regular income (har mahina byaaj milta hai). 
 
The income-tax (I-T) laws in India are biased against FDs and tilted in favour of mutual funds (MFs). This is because the interest you earn on FDs is fully taxable, but your capital gain on MFs is not.
 
Setting aside equity MFs (too risky for the conservative souls who invest in FDs) let’s talk about debt funds (DFs) which invest your money in bonds, issued by rated corporate customers.
 
Let’s say you have Rs5 crore to invest. Either FDs or DFs will give you 5%-6% return, which means that your annual income will be Rs25 lakh-Rs30 lakh, placing you in the highest tax bracket with a marginal tax rate of 30%.
 
If you put Rs1 crore in an FD, you will earn Rs6 lakh per annum (pa), on which you will pay tax of Rs1.8 lakh pa (assuming a marginal tax rate of 30%). Over three years, you will pay tax of Rs5.4 lakh.
 
If you put the money in a DF, which grows at 6% annually, the same rate as the bank FD, at the end of three years, Rs1 crore will become Rs1.18 crore (ignoring the compounding effect). If you sell the DF, you will have a capital gain of Rs18 lakh. The I-T on this gain will be calculated thus:
 
Net capital gain = gross capital gain, minus indexation.
 
Income Tax = 20% of net capital gain.
 
Indexation means: from the Rs18 lakh, you will be allowed to deduct the average inflation over the three years for which you have held the DF. If inflation has been, say, 4%pa, you can deduct Rs12 lakh (4%pa X 3 years) from your gross capital gain to arrive at a net capital gain of Rs6 lakh, on which you will pay income tax of Rs1.2 lakh (rate on the net capital gain on DFs is 20%).
 
The math is simple: Tax of Rs5.4 lakh on FDs and Rs1.2 lakh on DFs.
 
Moreover, if you simply hold a DF for three years and not sell it, you will book zero capital gain in this three-year period and, hence, pay zero tax, while the bank will deduct TDS (tax deducted at source) on the accrued interest on your FD every quarter for all three years. If you are trying to compound the money though FD (that is trying to earn interest on interest), it is a double whammy.
 
You may ask – what about the risk on DFs? Good question!!
 
Yes, DFs are inherently more risky than bank FDs. There are many types of DFs, apart from many different fund managers who run or manage them. Some of them are quite risky, and you could lose some of your capital if the DF turns out to be holding debt of a defaulting company.
 
But there is one type of DF whose risk is only slightly higher than that of a bank FD – short term DFs which invest only in corporate debt which is due in a maximum of 90 days. The return on such DFs is only slightly higher than that of a bank FD; but, even if you take a DF that gives a lower return than a bank FD, on an after-tax basis you will still be ahead, as this simple math will show.
 
Say, investment period = 3 years, bank FD rate = 6%, short term DF yield = 5%, inflation = 4%, your marginal tax rate = 30%.
 
Post-tax returns will be: bank FD – 4.2%, short term DF – 4.8%.
 
Beware: choosing the right DF is important, and if you are not market-savvy, finding the right adviser (a registered investment adviser - RIA registered with Securities and Exchange Board of India—SEBI) is perhaps even more important—otherwise your choice may be influenced by your relationship manager, based on the commission that he gets from the DFs he recommends for you.
 
So, only an idiot will put money in an FD, right?
 
I asked my nephew, a senior honcho in a leading private bank, why people put money in FDs and not DFs. His answer was very concise: 'Because they don’t know'.
 
But I did know and, hence, all my life-time savings were sitting in DFs for years, during which I paid practically no I-T.
 
Pandemic Changes the Equation
 
But everything changed in March 2020, when COVID-19 struck and India went into lock-down.
 
I put on my thinking cap and reflected back on the happenings in February 2007.
 
HSBC had disclosed large losses in its US subsidiary which was heavily into sub-prime lending. The market reacted with derision (‘these limeys have no clue about the US market’, etc); but I thought differently. 
 
HSBC, I reasoned, was a conservative bank, not prone to huge gambles. The Bank must have taken adequate safeguards when lending to sub-prime borrowers. If, despite this, if it had incurred big losses, there must be a systemic problem in the sub-prime business which was bound to surface and hit all sub-prime lenders, sooner or later.
 
So I sold all my mutual fund investments and moved the money into foreign currency non-resident (FCNR) deposits. I was a non-resident Indian (NRI) and there was no sub-prime lending in India!
 
Sure enough, the sub-prime bubble burst, the markets went into a tailspin, and the rest is history. My capital yielded less, but it was safe.
 
This time around I thought similarly:
 
- Nobody knows how big the COVID problem is.
 
- If it really is as big as some predict, all economies will suffer greatly and many businesses will go down.
 
- If corporates are in a bad shape, their share prices will fall and the equity market will collapse.
 
- Corporates will start defaulting on bond repayments and the DF market will collapse.
 
- Next the corporates will default on their bank loans and banks will suffer huge non performing assets (NPAs).
 
- The government will support State Bank of India (SBI0 and, maybe, some of the big private banks, considered too big to fail.
 
- Whether or not this doomsday scenario actually happens will be known only many months from now; but the risk is real.
 
So I sold all my DFs in a single day and put the money into bank FDs.  
 
Yes, I am paying I-T, a fairly hefty amount, too.
 
As of now the jury is still out on the ultimate impact of COVID. Yes, nearly a lakh of unfortunate souls have perished already, but some optimists will ignore this number as being less than the number of deaths in road accidents (despite minister Nitin Gadkari’s valiant efforts). Two-wheeler sales are up; Diwali is around the corner; the markets have held up; Modi-ji is going strong, etc, etc.
 
But, bad loans are yet to surface. Loan moratoriums and rescheduling have kept NPAs at bay. Many corporates have suffered severely; but nobody knows what exactly is happening.
 
We will begin to know the real situation after March 2021 when COVID has (hopefully) gone away, corporates start declaring their annual results and banks are forced to label their problem loans as NPAs.
 
If all goes well and everything is back to normal, I will go back to my beloved DFs. All that would have happened to me is that I would have lost some money and paid some tax (my humble contribution to the revival of the economy); but my capital would be almost intact. 
 
And, I would be proved to be an idiot and a pessimist.
 
But what if things go the other way? 
 
Perish the thought! I would rather be an idiot than see my country suffer.
 
(Deserting engineering after a year in a factory, Amitabha Banerjee did an MBA in the US but returned to India to be a ‘first-class citizen in a second-class country’, rather than the other way around. Choosing work-to-live over live-to-work, he joined banking and worked for various banks in India and the Middle East. Post-retirement he returned to his hometown Kolkata and is now spending his golden years travelling the world (until COVID, that is), playing bridge, befriending streaming services and writing in his wife’s travel blog.)
 
Comments
2502krishna
11 months ago
thanks for the post.. very good insights..
also does NSC FD count as DF's or FD's? what are some typical DF's
ganesanjaicare
11 months ago
now itself it is started relecting in share prices. only kotak and hdfc bank nearing. new high. but land t and mand m financial not at all moving an inch.other bank stocks still languising low without moving up.ten stocks are taking the index higher. if it continues those ten stocks will reach strong bubble zone.better to put noney in bank fixed deposit that too in public sector bank.one may lose opportunity. instead of losing capital losing opportunity is always better.
Nahom
11 months ago
DF another attractive tax saver: Adjustment of brought forward losses in Equity/Debt MF. Also Equity MF favoured by Tax laws vs direct share purchase.
sajjanisaac
11 months ago
If you were a NRI, interest on NRE FDs would be tax-exempt.
AJ_AJ
11 months ago
Interesting article that seems to... reinforce behavioural biases? Your money is 'safe' in FDs, but not against inflation, not safe against operational failures of banks, nor against your own death (why burden your next of kin with running from pillar to bank manager?). Better would be to just buy physical gold. That's the safest option for someone fleeing capital markets.
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