After the recent budget in July this year, a lot of investors are quite mindful of whether they should still invest in debt mutual funds given the changes in tax treatment that were announced with  regards to debt mutual fund schemes.

As per the new tax rules for debt mutual funds, if you hold an investment in a debt mutual fund for a period which is less than thirty six months, the capital gains on this investment will be short term capital gains and will be taxed as per your tax slab. For investments held for greater than thirty six months the taxation is at twenty percent with indexation benefit.

As the earlier holding period for such investments from taxation perspective was twelve months, this new extended holding period is making many investors rethink their debt investment strategies. In fact, a whole lot of investors may even just be investing in Bank FDs and not considering debt fund investments for the short term at all. Let us examine if there is merit in using debt funds and how do they compare against bank FDs.

Let us assume that you had invested in a bank FD in September of last year. Some of the leading banks at that time were offering rates for one year FDs as detailed below. We are also assuming a one year holding period of investment.

As we can see, after the new tax rules have come in, there has been a reduction in the rates of returns on short term debt mutual funds, but even so, as they are market linked and they do present the potential to deliver returns that could be a tad better than your bank FD investment. In addition, if your money is idle in your savings bank account then for every Rupees one lakh idle there, you are potentially losing approx. Rupees four thousand in a year. Needless to say the more money that is idling in your savings bank, potentially the more you lose.

Short term debt funds also score on some other parameters such as no penalties on premature withdrawal, subject to exit loads which are usually nil for liquid funds/ultra short term funds or upto 3/6 months for short term funds. Some other benefits that debt mutual funds especially short term ones, offer are

Now let us assume that you had invested in a debt mutual fund in September of 2011. We are also assuming that this was a three year investment. Let us examine the scenario now.

As can be seen from the above table, even today, because of the indexation benefits available to debt mutual funds, the post tax returns for long term investments (held for greater than thirty six months), is a clear winner in terms of rates of return. As India progresses on the path to control inflation and the CII factor (cost inflation index) used for indexation improves this benefit may change.

Currently the situation seems to be in favour of debt mutual funds.