CHAPTER 6: Leveraging on Higher Interest Rates & Higher Inflation through Debt Mutual Funds
In the last few months, most of the major economies around the globe are witnessing interest rate hike cycle. The primary objective behind these rate hikes is to bring the inflation under control. Despite continuous rate hikes, some major economies, such as the United States and the United Kingdom, are still struggling to keep inflation within their tolerance levels .
When credit or loans are
made available at a lower cost to individuals or large corporations, the money
supply in the economy expands and the size of the economy begins to grow
exponentially, resulting in inflation. Soon comes the time when this excess of
cheap money starts to hurt the economy as prices of goods and services increase
due to massive demand. This was our post-pandemic experience from 2021 to about
May 2022.
To control inflation,
one of the weapons central banks adopt is "tightening of monetary
policy," which means increasing interest rates (the repo rate of the RBI).
This raises the interest rate on credit or loans, reducing the availability of
money in the economy and causing a gradual slowdown. This is what we have been
experiencing since June 2022 to date, and despite the rate hike, inflation is still
not under control and remain sticky.
Effect of Higher Interest
Rates on Investors' Portfolios
When the repo rate of the
RBI was around 4%, the bank FD rate was around 5.10% to 6%. Today, when the
Repo Rate is 6.50%, banks are offering interest on fixed deposits of around 7%
to 7.50%. Higher interest rates penalise the borrower (home loan or car loan
buyer), but investors get a higher interest rate on their bank deposits or get
higher yields in Debt Mutual Funds.
How Debt Fund are tax
efficient than conventional FDs.
Gains earned from Bank
Fixed Deposits are taxable as per the individual's tax slab, irrespective of
the duration for which the FD was kept with the bank. On the other hand, the
gains from debt mutual funds are subject to short-term and long-term capital gains.
If debt mutual funds are redeemed after holding them for more than 36 months,
then such long-term capital gains are taxed at 20% with the indexation
benefit. Any gains made on redemption before 3 years are treated as short
term capital gains and taxed as per an individual's tax slab.
What is indexation?
Indexation is a method adopted to adjust the cost of an investment with respect to inflation and arrive at an inflation-adjusted taxable gain. Let us examine the tax efficiency of the FD vs. debt fund comparison for long-term investment using the table below. To arrive at an indexed value, the CII index (cost inflation index) is used, which is published on the income tax website.
From the above calculation, it is evident that post-tax gains above 3 years in debt mutual funds are higher than Banks Fixed Deposits. Tax liability on gains from fixed deposits is Rs. 4,500.86, whereas for the same rate of interest and same time frame, tax liability arising from gains made from debt mutual funds is just Rs. 1,590.29.
In a higher interest rate scenario and a higher inflation period, investors in debt funds are likely to gain better returns than Banks Fixed Deposits due to higher yields as well as better post-tax returns on the expected higher CII index (which is linked to the inflation rate).
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