Debt Fund VS Fixed Deposits

Debt Funds are becoming an increasingly widespread rival to the hallowed FD. Here are their pros and cons vis-a-vis bank deposits.

The bank deposit has been the instrument of choice of generations of low-risk investors. However, it is becoming harder and harder to ignore the challenge presented by debt funds. The two serve a similar function and are close rivals. The primary areas of difference are returns, safety, taxation, liquidity and returns with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.

Safety First

Bank Deposits are one of the safest avenues for savers in India with an almost negligible chance of default (although there have been instances of co-operative and local banks defaulting). As with all mutual funds, there are no guarantees in debt funds. Returns are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in. However, that’s a legalistic interpretation of the safety of your investments in mutual funds.

In practice, the fund industry is closely regulated and monitored by the regulator, Securities, and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund’s declared goals. In the past, these measures have proved to be highly effective and problems have been infrequent such as during the 2008 crisis and more recently with Amtek Auto and JSPL. Another common risk faced by debt funds is interest rate risk with funds losing value in a rising rate scenario and vice versa. Fixed Deposits which have been locked in for long tenures also face this risk in terms of opportunity cost but there is no actual loss of value when the deposit is held to maturity.

Taxation

The other big difference is that of taxation. Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 percent) tax bracket, this takes away a large chunk of their returns. Banks also deduct TDS on interest income from fixed deposits. The tax rates are similar for debt funds held for less than 36 months (though TDS will not generally be deducted). However, for debt funds held longer than 36 months, returns are classified as long-term capital gains and are taxed at 20 percent with indexation.

Liquidity

Turning to liquidity, open-ended debt funds proceeds are credited within a period of 2-3 working days depending on factors such as whether an ECS mandate is registered. Fixed Deposits are also typically available at 1-2 day’s notice but usually carry a penalty if they are redeemed before the maturity date. Debt funds also have exit loads or charges that are usually levied for redemptions, typically up to 3 years. These exit loads are not applied to liquid funds with just a few exceptions for very short periods of time.

Returns

As the returns of debt funds demonstrate, you can beat the bank by investing in debt funds. Debt fund investors assume both credit risk (lending to riskier borrowers) and interest rate risk (the risk of bond prices falling when interest rates rise) and are hence compensated by higher returns.

In summary, you can beat the bank by investing in debt funds instead. However, you should be cognizant of the risks involved and choose the right fund in order get the best possible deal.