Fixed Deposit or Debt Funds - Which One Is Better For You

Stuck with the dilemma of whether or not to park money in alternative investment options rather than the tried and tested, parent approved - fixed deposits for a period of three to five years?  Debt funds may be your answer. Bearing much similarity, here’s how fixed deposits compare to debt funds. For a longer time horizon, equities are the best option. 

Debt funds typically invest in government securities and high-rated bonds for a mid to long term duration. Given the instruments they invest in, these funds are generally steady and bear higher returns than fixed deposits with a minimal increase in risk.

Fixed Deposit vs Debt funds - How They Compare

Returns

Fixed Deposits provide a fixed and predictable income regardless of the market conditions. These returns (averagely seven per cent) are generally lower than that offered by debt funds (averagely between nine and eleven per cent).

Says Soumya Sarkar, Co-Founder, Wealth Redefine, a financial planning firm, “For a three to five year horizon, it is advisable to choose medium to long-duration debt funds. These funds have the potential to deliver better returns over a longer period, as they are structured to take advantage of the interest rate cycles.” In a falling interest rate environment, an investor in debt funds can hope to make additional money because of duration benefit.

Liquidity

Debt funds offer more flexibility in case of financial emergencies. There is no lock in and you can withdraw funds as per your needs. Says Gaurav Goel, Securities and Exxhange Board of India Registered Investment Advisor (RIA), “Debt funds can be redeemed at any point but most banks levy a premature penalty if fixed deposits are broken before maturity.” This penalty can go up to one per cent. 

Risk

Fixed deposits are the safest investment instrument today as there is no fluctuation in the return rate and practically no risk. The risk of a bank defaulting is very low especially considering the safeguarding mechanisms the RBI has enforced. In comparison, the likelihood of a corporate defaulting is relatively higher. Debt funds carry the risk of bonds held within the fund defaulting. However, if you opt for low credit risk options, the risk of default for debt funds is minimal as well. 

Debt funds are exposed to interest rate risk as well, An environment of increasing interest rates could bear detrimental impacts on returns offered by debt funds. 

Taxation

With the removal of indexation benefits, debt funds are now taxed as per your individual tax bracket. This means the tax implications of Fixed Deposits and debt funds are at par. Debt funds do however, provide some degree of flexibility on when this tax is realised. Says Sarkar, “Debt fund gains are taxed only when you redeem them, allowing some flexibility in tax planning, while Fixed Deposits are taxed every year on the interest earned.”

Over a three-to-five-year horizon, debt funds offer better returns, more flexibility and greater liquidity compared to fixed deposits. It is suitable for those of you with a low to moderate risk appetite looking for a steady income. If you are absolutely risk-averse, fixed deposits may be a safer option.