Ultra short-term debt funds boost post-tax returns

Sanjay was on the phone the last five minutes as Sanjana sat across the table at a neighbourhood coffee shop. When he finally finished his call, she asked what took him so long.

Sanjay smiled. “My relationship manager from XYZ Bank. She was offering me advice on managing my money.”

“Oh good, so now you are a special customer of your bank and have a dedicated relationship manager?” she asked.

“Yeah, I became their special customer since I started maintaining an average balance of `200,000 in my savings bank account and fixed deposits. And I shall continue to be, till the time the average balance is maintained,” he said, visibly proud of his accomplishment.

“So you maintain a balance of Rs200,000 in your bank account just to have the privilege of a relationship manager? You are happy to forgo the return on your money?” asked Sanjana.

Sanjay was quick to reply. “No, who says I am not earning returns? My savings account gives me 4% and bulk of the money is in fixed deposits, which earns me anywhere between 7% and 10% per annum. You see, my money has been effectively employed for providing returns plus special customer benefits.”

“Those are absolute returns. Have you ever thought about post-tax returns? If I am not wrong, you are in the 20% tax bracket.”

Sanjay nodded.

Sanjana continued: “Even if I assume the fixed deposit gives you 10% per annum, a 20% tax would leave you with post-tax return of 8%.”

Sanjay was annoyed. “Well, that’s the best return I can get for liquidity and low risk. You told me the other day that one needs to compromise on returns if he is not willing to take risk and wants liquidity.”

“That’s true,” said Sanjana. “Savings accounts or fixed deposits are the best place for high liquidity and minimal risk returns. However, why maintain a huge balance in your savings account when there are other low-risk, high-liquidity alternatives available, providing better returns?”

“Can you elaborate?”

“Sure,” said Sanjana. “See, I am not against maintaining adequate money in savings/ fixed deposits. This is required for any unforeseen immediate requirement. However, one can pep up the returns by investing the excess portion of the money lying in savings account in debt funds, which provide liquidity along with low risk and high returns.”

He was all ears.

“I am referring to ultra short-term debt funds offered by mutual fund companies. These funds provide tax-efficient returns with liquidity and low risk. I agree that these funds are not as safe as fixed deposits, but given the low maturity profile of these funds, the risk of losing money is minimal,” she continued.

“Go on,” said Sanjay.

“These funds, earlier known as liquid plus funds, invest in short-term debt papers, which have maturity of more than 90 days but less than a year. Barring a few, they do not have any entry or exit load can be redeemed at any time with the proceeds credited to bank account by the next day or at the most, the day after, depending on the timing of redemption. Since they invest in debt instruments and commercial papers of corporates, their returns are attractive even after deducting fund management expenses. In the last 12 months, good ultra short-term funds managed to provide returns anywhere in excess of 10% to 9%. However, the most important factor which tilts the pendulum in their favour is their tax treatment. Though any gains arising out of such investments are treated as capital gains and taxed at applicable short-term or long-term capital gains rate, many of these funds provide a dividend option and facility to reinvest dividends. Now, dividends are taxed at lower rates and this boosts the post-tax returns.”

She continued: “Let me give you an example. If you invest in such funds with daily dividend reinvestment option, any increase in NAV during the day is declared as dividend by the fund and gets reinvested after paying dividend distribution tax at 12.5% plus surcharge and education cess. Since dividend is tax-free, it is not taxed in the hands of the investor. Since the entire gain is declared as dividend, the NAV of the fund remains unchanged and there is little or no capital gains tax at the time of redemption of units.” Turn to Page 14

Ultra short-term debt funds boost post-tax returns

“So you are saying that there is only dividend income, on which the fund pays the tax @ 12.5% and that dividend is tax-free for me? Since this tax rate is less than the tax @ 20% which I pay on interest income from fixed deposits, even if the fund earns 10%, my post-tax returns are better than post-tax returns on fixed deposits. And if one falls in the highest tax slab of 30%, it is even more beneficial, right?”

“Absolutely,” said Sanjana. “Tax benefit varies according to one’s tax slab. For persons paying 30% tax, the benefit is the highest.”

“But if they are tax efficient, why just ultra short-term debt funds, which invest in debt papers with maturity of more than 90 days, I can also invest in funds which invest in debt papers with maturity of less than 90 days, can’t I? I am sure there are such funds in the market,” asked Sanjay.

“Correct. There are funds which invest in debt papers with maturity of less than 90 days --- those are called liquid funds. However, they are not tax efficient, since dividend distribution tax on dividend distributed is 25% plus surcharge and education cess. Thus, on a post-tax return basis, they are at a disadvantage against ultra short-term debt funds,” she said.

“Oh, okay. So ultra short-term debt funds provide high post-tax returns if one opts for dividend reinvestment option. They are liquid investments, though slightly riskier than bank fixed deposits. And one can pep up their returns by investing surplus funds in them.”

“Bingo,” said Sanjana as Sanjay’s mobile rang again.

Sanjay disconnected the call. “Who needs a relationship manager when I have such a good friend providing free financial advice?” he said, sipping cappuccino crowned with chocolate sauce.

The writer is a chartered accountant. He blogs at http://bachhat.blogspot.com