Fixed Deposits Vs Debt Mutual Funds: Which is better?
Jun 19, 2017

Author: PersonalFN Content & Research Team

When it comes to financial investments, most individuals are averse to taking risks.

Who would want to lose their hard-earned savings due to misinformed financial decisions?

Most prefer guaranteed returns and avoid volatility. It is no wonder that a bulk of Indian household savings are in bank fixed deposits.

Those who venture out in search of higher returns, fall for Ponzi schemes that promise “high return on capital with no risk.” Thousands of crores of hard-earned money has been lost to chit-fund scams like those of the Rose Valley Group and Saradha Group.

Others may invest in corporate fixed deposits that offer a high interest rate, but these are not backed by strong financials or the management’s intent to repay. In the past, companies such as Unitech, Jaiprakash Associates and companies promoted by Yash Birla that have either delayed or defaulted on payment of interest or principal or both.

Sadly, most individuals are unaware of the benefits of mutual funds. While mutual funds offer several asset classes to choose from, debt mutual funds are a good alternative to bank fixed deposits. However, you need to choose wisely.

With declining fixed deposit rates, the interest in different investment avenues is growing. In this article, PersonalFN outlines the key differences between fixed deposits and debt mutual funds while covering the common questions you may have about the two.

What are debt mutual funds? How are they different from fixed deposits?

Unlike fixed deposits, where the rate of interest is known before investment, debt mutual funds diversify your investment over money market securities such as commercial papers and certificate of deposits, government securities, corporate bonds or corporate deposits. The allocation to these securities depends on the investment objective of the scheme.

To put it simply, under fixed deposits, you directly invest your money with the issuer. In debt funds, you invest the money indirectly through the fund house. The fund manager decides in which securities to invest, keeping in mind the investment objective of the scheme and focusing on high risk-adjusted returns.

How do debt mutual funds work? Do they pay a fixed interest like fixed deposits?

While fixed deposits either pay or accumulate the interest at a set date, the return of debt mutual funds is represented by their Net Asset Value (NAV).

As the underlying securities are traded in the market, similar to stocks, the value fluctuates depending on the liquidity and the direction of interest rate. Thus, when interest rates rise up, the value of the bonds and in turn your NAV falls. When rates head lower, the reverse happens. Thus, when RBI cuts interest rate, the value of the debt fund investment is expected to increase and earn a higher return.

As these are interest bearing securities, the yearly interest is divided by 365 (no. of days in the year), and the debt fund’s NAV goes up daily by this small amount.

Under debt funds, there are dividend options also available, which can be monthly, quarterly, or yearly. Therefore, similar to the interest pay out of fixed deposits, you may choose one of these options if you are looking for regular income. Please note, that the dividends paid out are post deduction of dividend distribution tax (DDT) of 28.84% (including surcharge and cess). Hence, this option is beneficial only if you are in the highest tax bracket.

Do debt mutual funds earn a higher return than bank fixed deposits?

There isn’t a straight answer to this question. As explained earlier, the returns of debt mutual funds are market linked. Therefore, the returns vary based on the schemes investment mandate, prevailing market conditions, and tax regime.

Schemes that invest in money market instruments or debt securities with a maturity period of a few days to some months, such as ultra-short term funds or liquid funds, carry a low risk; hence, the returns too may be lower. However, certain schemes in the category are able to deliver a higher return than bank FDs if the market conditions are conducive.

Short-term debt schemes invest in maturity assets of up to 1 year or more. Here the returns, though higher, may be more volatile than liquid schemes. Over a period of 2-3 years, most short-term debt schemes have the potential to deliver a higher return than bank FDs.

Income funds invest in securities of various maturities. Under most such schemes the portfolio is skewed to instruments with longer maturity. Income funds and similar long-term debt funds are more volatile, and the interest rate cycle plays a crucial role. In a period of rising interest rates, debt funds that invest in longer term securities may not offer the best returns; hence, these may trail the returns of bank deposits. However, in a falling interest rate scenario, these same schemes will be able to deliver high returns on investment.

What about the tax implications?

Debt mutual funds and bank fixed deposits are taxed differently.

The interest earned on bank fixed deposits are added to your total income (under the head ‘income from other sources’) and taxed as per your income tax slab. While in the case of debt mutual funds, if you redeem your investment before three years, the gains (also known as Short Term Capital Gains (STCG)) are added to your income and taxed accordingly.

For redemption of units which are held for a period of three years or more, the Long Term Capital Gains (LTCG) are taxed at a rate of 20% with indexation. The indexation benefit, aids to lower the tax impact, and is useful, especially for those in the higher tax brackets… and this is where debt funds score over bank fixed deposits. Due to a lower tax on investments greater than 3 years the debt fund tend to score a higher post-tax return as compared to bank deposits.

It is always important to keep up-to-date with the prevailing tax laws. If the Government changes the tax rules – like it did in 2014 – the benefits may get impacted. Earlier, withdrawal from debt funds attracted LTCG tax of either 10% (without indexation) or 20% (with indexation) and the holding period to qualify as long term was just 1 year.

What are the risks associated with debt mutual funds?

Debt funds primarily run two risks: the interest rate risk and the credit risk.

The market value of tradable securities held in a debt fund drops when the interest rates in the economy rise, and as a result, the Net Asset Value (NAV) of a fund drops. Since securities are redeemed at par value on maturity, those who can hold out until maturity don’t suffer much, but speculators who try to time interest rate movements do.

The credit risk, or risk of default, is a much bigger concern for debt fund houses. This is because, if the company issuing securities goes belly up, debt funds incur losses that can’t be recovered easily. Therefore, it is essential to check if your fund is investing in highly rated debt securities. Low rated debt securities offer a higher interest rate, but with higher risk. Credit opportunity funds that adopt an accrual strategy benefit from this, with an increased credit risk to generate a higher yield. Schemes that have a high concentration of low quality assets should be clearly avoided. Liquidity too, is a cause of concern in low-rated debt securities. It can get worse if the credit rating deteriorates and the fund manager is unable to sell his holdings.

In the past, JPMorgan India Short Term Income Fund and JPMorgan India Treasury Fund bore the brunt of its corporate debt holding in Amtek Auto. The Amtek Auto security was de-rated to junk status, which led to severe mark-to-market losses for the fund. Due to the lack of buyers, the fund was unable to sell its holding.

At the same time, it is important to note that fixed deposits too are not devoid of risk. While your investments in well-known banks may be relatively safe, you should avoid entrusting your hard-earned money to shady and not-so-strong co-operative banks. Many cooperative banks in India have gone bust in the past; hence, it is best to stay away.

If you are opting for a corporate fixed deposit of an NBFC or others, due diligence is critical before parking your hard-earned money. Corporate FDs are not guaranteed investments; hence, you need to check the credit rating and financials of the company before investing.

Where should you invest—Debt mutual funds or fixed deposits?

Remember, compared to banks FDs and some Small Saving Schemes, the rates for which have been a downhill, investing in debt mutual funds can prove more rewarding and tax efficient.

But you ought to take enough care when selecting winning debt mutual fund schemes for your investment portfolio, because debt funds aren’t risk-free. If you need superlative research based guidance to select debt mutual fund schemes, opt for PersonalFN’s DebtSelect, if you wish to earn higher returns with some element of risk.

On the other hand, if you don’t have a stomach for risk and prefer stable and guaranteed returns, then stick to fixed deposits. Open an account with reputed private or public sector banks where the risk of going bust is low.

In PersonalFN’s view, it would be imprudent to invest at the longer end of the yield curve, which is in long-term debt funds holding longer maturity debt papers. It is vital to note that most of the rally has already been captured at the longer end of the yield curve.

Going forward, if RBI increases policy rates by any chance (enabled by the change in monetary policy stance from ‘accommodative’ to ‘neutral’) and if inflation pops up its ugly head, it could be perilous for your investments in long-term debt funds.

So, it would be better to deploy your hard earned money in short-term debt funds if you’re risk averse, but ensure you’re giving due consideration to your investment time horizon.

For an investment horizon of upto 2 years, consider investing in short-term debt funds.

If you have an investment horizon of 3 to 6 months, ultra-short term funds (also known as liquid plus funds) would be the most suitable.

And if you have an extreme short-term time horizon (of less than 3 months), you would be better-off investing in liquid funds .

Don't get swayed by distributors, relationship managers, or wealth managers who push hybrid mutual fund schemes such as Monthly Income Plans (MIPs) or Equity Savings Schemes (ESSs), or balanced funds as alternatives. These schemes include an equity component in their endeavour of wealth creation, which may be unsuitable if you were to evaluate investment avenues against bank FDs, due to the high risk involved. When you invest, ascertain your risk profile prudently; so as to have suitable investment avenues in your portfolio.

Again we would reiterate, if you are undecided about which funds you can reliably invest in, subscribe to PersonalFN’s DebtSelect, where you’ll be entitled to a bi-monthly research report on debt mutual funds which can help you be an empowered investor. Be rest assured about the unbiased nature of this service.

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