Fixed Deposit vs Debt Fund

Bank Fixed Deposits (FD) is the traditional investment vehicle for most Indian households. According to a recent RBI report nearly 50% of household financial assets in India are in FDs. Debt mutual funds, though not as popular as equity mutual funds among retail investors, also have grown in popularity over the last several years. However, in terms of household financial assets investments in debt funds is still a small fraction of FDs. Let us analyse the main differences between debt funds vs FD, so that you can make informed investment decisions.

1. Risk

   FDs pay back the principal amount along with accrued interest on maturity. If you compare debt funds vs FD on risk parameter, the bank provides assurance of capital safety and as such, FDs are thought to be risk free investment. However, if the net worth (assets – liabilities) of the bank becomes negative due to high NPAs, then the bank may default on the FDs. Though bank defaults are very rare, it is within the realm of possibilities. In case a bank defaults, investors’ deposits – both principal and interest are guaranteed up to Rs 5 lakhs* i.e. even if a bank defaults you will get up to Rs 5 lakhs. If your investment is more than Rs 5 lakhs, then you may not get any compensation for the loss exceeding Rs 5 lakhs.

   Debt mutual funds invest in debt and money market instruments like, commercial papers, certificates of deposits, corporate bonds, Government bonds etc. Debt funds are subject to market risks and there is no assurance of capital safety. There are two kinds of risk in a debt funds – interest rate risk and credit risk. Interest rate risk of a debt fund depends on the duration profiles of the funds. For example debt funds which invest primarily in money market instruments have less interest rate risk, while Gilt funds of long maturities have higher interest rate risk. Credit risk depends on the credit ratings of the underlying securities. Investors should understand the risks and invest accordingly. This is the difference if you compare debt funds vs FD on risk metrics.

^{*Source- Reserve Bank of India website}

2. Annualized returns

   FDs pay compound interest at a fixed rate over the FD term. FD interest usually compound quarterly. FD interest rates have been declining for several years. Currently 2 – 3 year FD interest rates for major public and private sector banks range from 5.1 – 5.4%. Unlike FDs, debt funds do not give assured returns. Returns of debt funds are market linked. Historical data suggests that debt funds have usually outperformed FDs of similar tenures. The chart below shows the annualized returns of different debt fund categories over the last 1, 3 and 5 years (periods ending 16th June 2020). Therefore, debt funds score over FDs if you compare debt mutual funds vs fixed deposits on return basis.

   

   ^{Source: Advisorkhoj Research – Returns as on 16/7/20. Past performance may or may not sustain in future.}
   
   

3. Liquidity

   Fixed deposit vs debt funds, if compared on the liquidity front, both are highly liquid. There is no lock-in in both, FDs and debt funds. However, some banks may charge penalties for premature FD withdrawals. Debt fund redemptions within the exit load period will attract exit load which is charged on the redemption amount. After the exit load period, you can redeem units without any charges. Some debt fund schemes e.g. overnight funds do not charge any exit load. You should check the exit load structure of debt funds before investing.

4. Taxation

   If debt funds vs fixed deposits is compared on taxation, interest on FD is taxed during the tenure of the investment and on maturity. The FD interest is added annually to the tax-payer’s income and taxed according to the income tax rate of the investor. Debt funds enjoy tax advantage over FDs especially for investors in the higher tax brackets. Short term capital gains in debt funds (investments held for less than 36 months) are taxed like FDs (Basis the income tax slab of the investor). Long term capital gains in debt funds (investments held for more than 36 months) are taxed at 20% only after allowing for indexation benefits. Therefore, long term capital gain taxation is a major advantage in debt funds if fixed deposit vs debt funds taxation is compared

5. Transparency

   If you compare debt funds vs fixed deposits, though FDs are very safe instruments, bank defaults cannot be ruled out of the realm of possibilities. Average depositors have very little information on loans given by banks, NPAs of banks, bad debts written off etc. Debt funds on the other hand are very transparent as the scheme portfolio is disclosed monthly by the AMCs in the factsheets with complete information, like instrument name, credit rating, and exposure of respective instruments in the scheme portfolio.

Conclusion

In this article, we discussed the differences between debt mutual funds vs fixed deposits on several parameters. If capital safety and assured return is of paramount importance then FD is the investment option for you. However, you can get potentially superior risk adjusted returns by investing a portion of your fixed income assets in debt mutual funds and can also enjoy taxation benefits in debt funds and that is the major advantage of debt mutual funds if Debt Fund vs FD is compared.

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