Debt Mutual Funds vs FDs

Debt Mutual Funds vs. Bank Fixed Deposits.

In the post demonetization era, investors are flush with funds. While the have parked their hard-earned money in banks, they are not sure about how to invest this money without taking too much risk. For such requirements, traditionally, fixed deposits have been the de facto choice.

However, in the recent past debt mutual funds have also emerged as a favourable option for scored well for risk averse investors. It is also led by the sharp fall in fixed deposit rates. Before weighing the pros and cons of the two investment options, let us understand them better.

What is a Bank Fixed Deposit?

A fixed deposit is a financial instrument offered by banks. It pays a fixed interest rate, which is generally higher than regular savings account for fixed tenure. On maturity, the investor has an option to renew the principal +/- interest at the prevailing rate. A bank generally deducts a TDS on the income.

What are Debt Mutual Funds?

Debt mutual funds are investment options offered by mutual fund companies. These invest in fixed income instruments, including government bonds, treasury bills, corporate deposits, money market instruments and other avenues that are generally considered safe. Debt MFs are valued on the underlying assets they hold. Generally, debt securities have a fixed maturity date, pay a pre-defined rate of interest and are more tax efficient.

Debt Mutual Funds vs Bank Fixed Deposits

The two investment classes can be compared on the basis of Returns, Safety, Liquidity, and Taxation.

  • Returns

As we know, fixed deposits only offer interest income. There is no capital appreciation. However, the returns of a debt mutual fund comprise of interest (on the bonds) as well as capital appreciation/ depreciation (in the value of the security due to changes in market). It is known that when bond process fall, interest rates rise and vice versa.

  • Safety and Risk

Bank Fixed deposits are one of the safest investment options with almost negligible risk of default. Since your money is locked for a long tenure, FDs face a risk in terms of opportunity cost, however there is no loss of principal.

On the other hand, Debt mutual funds are exposed to Credit Risk (the possibility of default by investee company) and Interest Rate Risk (Loss of Net Asset Value in rising interest rate scenario).

Debt Funds are closely monitored by Securities and Exchange Board of India (SEBI), that vets the risk profile of underlying investments. Debt securities are also assigned ‘Credit Ratings’, that help investors assess the ability of the issuer of the securities / bonds to pay back their debt. These ratings are issued by organisations such as CARE, CRISIL, FITCH, Brickwork and ICRA and are considered highly reliable.

Liquidity

Fixed Deposits offer best returns only if held till maturity. However, if a withdrawal is necessary, there are options for premature withdrawal. However, few banks also allow partial withdrawals or temporary overdrafts. Prematurely withdrawal of a fixed deposit results in lower rate of interest and penalty. Most banks charge 0.5-1% as penalty for the premature closure of Fixed Deposits.

However, in case of a most debt funds (except Fixed Maturity Plans), the investor has the option to redeem the units (partially or fully), without a penalty. Some debt funds may charge exit loads based on the investment tenure.

Taxation

Interest income from FDs is clubbed with an individual’s total income and taxed as per the applicable tax slab. However, the returns of mutual funds are taxed under the head ‘Income from Capital Gains’ as per the following:

Term Short-Term Capital Gains Long-Term Capital Gains Dividend Income
Holding period 3 years or less More than 3 years Tax free
Taxable @ 20% with indexation benefit Income tax rate applicable to the investor Tax free

Hence, debt funds are more tax efficient as compared to fixed deposits, especially for investors in the highest tax slab.

The debate on FDs versus Debt Funds is settled by taking an informed decision depending on your financial goals, long-term requirements, and of course, your risk-taking ability. One can choose from the various types of debt funds offered by AMCs.

Perhaps, the single largest consideration that one should have is “real returns”. In an inflationary scenario, investments that do not earn a real return are counterproductive. Hence, clients should be educated and informed about the need to combine caution with aggression and go for a balanced approach.

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