How Fixed Deposits Compare With Debt Funds

Risk-averse investors in general and senior citizens in particular prefer to invest their hard earned money in bank fixed deposits. Even for most of the relatively suave investors, bank FDs still remain the most popular form of short-term investments (less than 5 years). However, if such investors are ready to take a little bit of additional risk in order to increase their returns, then they can consider debt mutual funds.

Here is a brief on debt funds and fixed deposits and the comparison of their features:

Debt funds: Debt fund is a broad category of mutual funds that seek to invest in securities generating fixed income. These securities can be government bonds, commercial papers, certificates of deposits, treasury bills, company bonds, debentures, money market instruments and/or other debt securities. Like other mutual funds, you can buy or redeem the units of debt funds at daily NAVs.

Fixed Deposits: Fixed deposit (also known as term deposit) is a fixed income instrument that offers capital and income guarantee till the date of the maturity of the instrument. The rate of interest also remains the same throughout the tenure of the investment.

How debt funds fare against fixed deposits

Capital protection: Your bank FDs (including both principal and interest component) of up to Rs 1 lakh in each bank is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) in the event of bank failure. Meaning, any bank deposits beyond Rs 1 lakh is as unsafe as any other financial instruments in the event of the failure of the bank.

Although the debt funds do not offer similar capital protection, the safety of such funds can be deduced from their underlying securities. These securities are rated by various credit rating agencies on the basis of their ability to pay back the maturity amount. Generally, debt funds invest in highly-rated securities where the possibility of default is negligible.

Return on investment: Bank FDs offer a fixed rate of interest irrespective of the movements in interest rates. For example, if you invest in an FD of 3 years tenure @ 7.9% p.a., you will continue to receive the same rate of interest till the end of the tenure, irrespective of the increase/decrease in the interest rate for that same tenure in the interim period. In otherwords, the rate of return of your bank FD is guaranteed.

Debt funds on the other hand, do not provide guaranteed returns. The return from a debt fund depends on the interest income earned from the underlying securities, the increase/decrease in the price of the securities, monetary policy and the investment management of the fund manager.

Liquidity: Banks allow premature withdrawal of FDs (except the tax-saving FDs) only in lieu of surrender charges or penalties. The liquidity of debt mutual funds is similar to that of equity mutual funds. Typically, you can withdraw your debt fund anytime without paying any charges.

Investment Costs: Typically, banks do not charge anything for investing in bank FDs. As far as debt funds are concerned, you will have to pay various annual recurring charges such as fund management fee, marketing & selling expense including agent commission, brokerage etc. As per SEBI regulations, the total annual recurring charges have been capped at 2.25% p.a. of the daily net assets.

Tax treatment: Interest earned from bank fixed deposits is added to your annual income for tax purposes. Hence, the tax on interest earned will depend on the tax slab that you come under. So, if your annual income falls in the 30% tax bracket, the interest earned from FD will attract 30% income tax. The banks deduct TDS if the interest earned on your fixed deposits crosses Rs 10,000 in a financial year.

In case of debt funds, short-term capital gains (gains made from investment of less than 3 year) is added to your annual income and taxed at applicable slabs. However, the return on investments of over 3 years is classified as long term capital gains, which is taxed at 20% with indexation benefits. The indexation benefit allows you to factor in inflation while calculating your capital gains. Therefore, even if the rate of returns from debt funds and fixed deposits are the same, you still stand to gain more from debt funds provided you come under 20% or 30% tax bracket and stay invested for more than 3 years.

Choosing between the two

Debt funds definitely score over bank fixed deposits in terms of return on investment, liquidity and tax treatment. Invest in debt funds if you need a place to park your funds but you do not have a fixed investment horizon or may need funds anytime. If your investment horizon is less than 3 months, invest in liquid funds instead of keeping your money in savings account. However, compare the FD rates offered with the returns provided by the debt funds for the same period of time.