Are Debt Funds an Ideal Alternative to Bank FDs?

For decades, fixed deposits (FDs) have been the staple investment option of every Indian household. However, due to the rise of modern investment options, there is currently a decline in FDs and a precise shift towards debt mutual funds. Vardan Pandhare examines why debt mutual funds are superior to fixed deposits

Every extra rupee, including bonuses and increments, was once guided towards bank fixed deposits (FDs). At some point during their lives, our grandparents and parents invested their money in FDs. It was the greatest way to earn extra interest while preserving the capital. What has changed then? In recent years, mutual funds have become more prominent. Due to this, FDs are no longer the most preferred long-term investment objective for many. Mutual funds were able to take advantage of the opportunity created by the 2016 demonetisation and the lower deposit return rates offered by FDs. Also, another trigger point which attracted investors towards mutual funds was the availability of tax-saving funds. One more crucial factor that turned the tide for fund houses and increased the trust for mutual funds as an investment avenue was the superlative digital and TV advertisement campaign. Sporting cricketing icons like Sachin Tendulkar and M S Dhoni churning out lines like “Mutual Fund Sahi Hai” surely created a buzz. And when among the plethora of offerings Debt Funds began giving more returns with liquidity, several low-risk investors decided to jump ship.

Deep Dive into Debt Funds

Debt funds are also mutual funds that invest in fixed-income securities like corporate bonds, treasury bills, government bonds, certificates of deposit, commercial papers and other similar items. The characteristics of debt funds are:

■ There is a predetermined maturity date for the debt fund-based income instruments.
■ Market fluctuations have little impact on the returns of debt investments.
■ Debt securities are one of the options that are considered ‘low risk’.
■ Investors who participate in debt funds receive regular interest income as well as capital growth.
■ The debt instrument’s issuer predetermines the interest rate that will be paid at maturity. n Fixed income securities are another name for debt funds.

Distinction between Debt Mutual Funds and Bank FDs

Risk —Banks are considered blue-chip institutions and thus when the danger of bank fixed deposits is compared to the risk of debt mutual funds, bank FDs are deemed to be risk-free investments because the risk is so minimal. The guaranteed interest rate on your fixed deposit is the rate at which you will receive interest payments. Deposit s are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) under RBI insurance up to a maximum of `5 lakhs even if the bank fails. Contrarily, as mutual funds are marked-to-market products, changes in interest rates and credit spreads affect them. Debt mutual funds, however, carry a marginally higher risk because it’s possible that the interest rates on fixed income instruments could alter in response to market interest rates. Compared to the risk on equity funds, this risk is still significantly smaller. Debt mutual funds often invest in securities with excellent track records and high credit ratings. Since the mutual fund involves investing in bonds and other debt instruments, investors should always verify the credit ratings of those securities.

Investment Flexibility — With a fixed deposit, you must invest all your money at once at the start of the investment period. With debt mutual funds, you can choose between making a one-time large investment or a series of smaller, more frequent investments through a systematic investment plan (SIP).

Additional Fees — In general, fixed deposits do not incur any extra fees. For example, fund management fees, which fund managers charge to manage your assets, and exit loads, which are assessed when you withdraw from a mutual fund scheme, may be minimally added costs for debt mutual funds.

Liquidity Factor — Debt funds and bank FDs, in contrast, are both fairly liquid investments that can be accessed at any time. However, depositors who wish to withdraw must do so during the early withdrawal period by breaking their fixed deposit and paying the associated penalty. If you remove from debt mutual funds before the allotted time, you will be charged an exit load of 1 per cent. After the stated exit load time, you can redeem units for no charge. Some debt funds don’t levy exit fees, such as overnight funds. In contrast to other debt funds, liquid funds have a high liquidity level and are simple to redeem.

Impact of Inflation — The repo rate, reverse repo rate and the resulting overall interest rates on deposits and loans may fluctuate with the rate of inflation since these essential policy rates are utilised by policymakers to curb inflation. So, the interest rate paid on FDs and the annual return or CAGR on debt mutual funds should be close to the rate of inflation to produce risk-adjusted, inflation-beating returns. The money invested in FDs would, however, lose its purchasing value if the rate of inflation were to outpace the interest rate regime, which would result in a negative real return on investment. FDs are thus viewed as instruments that are poor at mitigating inflation. On the other hand, because debt instruments can be sold in the secondary markets, debt mutual funds may be able to partially offset the impact of an increase in the inflation rate. Moreover, debt funds can benefit from indexation when calculating long-term capital gains (LTCG), making them inflation-efficient. Difference between fixed deposits and debt funds. 

Rate of Return

The return on a debt fund may also be relatively consistent and predictable, whereas the return on a bank FD is fixed and has a predetermined maturity amount with fixed maturity items in its portfolio. However, because the debt securities held by a debt fund may be exchanged in the secondary markets, the fund’s net asset value (NAV) may change, resulting in returns that are either higher or lower than those generated by the fixed return securities held by the fund. Mutual funds can provide returns that are higher than FDs when they are actively managed. Depending on the macroeconomic environment, the fund manager might deliberately prolong the duration or accept credit risk, positioning his fund to profit if his predictions come true. Liquid funds may produce returns that are higher than the portfolio yield if interest rates start to decline and vice versa. 

FD returns are at the same rate for the duration of the investment. The two most common assets for conservative investors are fixed deposits and debt mutual funds. Although interest rates have increased, fixed deposits have proven to be a safe option for Indian retail investors. Debt funds often provide better-annualised returns than FDs. While being the riskier alternative to FDs, debt funds have slightly higher yields, ranging from 7-9 per cent as opposed to FDs’ 6-8 per cent. Debt funds and fixed deposits, however, have significant tax differences.

Taxation of Fixed Deposits and Debt Mutual Funds

Gains on debt funds that have been held for less than three years are taxable at your tax rate. Gains on long-term debt funds (i.e. up to three years or longer) are taxed at 20 per cent with the benefit of indexation. The gains on fixed deposit returns will be taxed according to your tax brackets.

Target Investors for Debt Funds

■ Debt funds are ideal for persons with short-term and medium-term investment goals.
■ Those that have a low tolerance for risk may want to consider these funds.
■ A person with extra money can put it into debt funds.
■ For investors wishing to diversify their portfolio, debt funds are an alternative.

Conclusion

Any investor’s tax-efficient investment alternative would depend on a variety of factors, including the investment return, the applicable tax rate, type of holding and the length of time. If capital security and guaranteed returns are important to you, a fixed deposit is the right option. While also offering tax advantages, putting a portion of your fixed income assets in debt mutual funds could lead to possibly higher risk-adjusted returns. Debt funds outperform FDs in a macroeconomic environment which is always shifting. They offer marginally higher yields while providing better benefits in higher tax slabs. Hence, it is wise to invest in worthwhile opportunities based on your eligibility to achieve higher risk-adjusted returns.