Are Debt Funds “Just Like FD’s”?

As the RBI dropped rates two years ago to counter the economic impact of the pandemic, banks were quick to pass on the rate cuts to FD investors. The low FD rate regime that persisted for a good two years piqued the interest of many retail investors into debt funds. Unfortunately, many investors went into debt funds, assuming they were just like fixed deposits, only to face disappointment later (the category average 2-year return from dynamic bond funds is barely 1.17 per cent as on date. If you’re contemplating debt funds, here are a few things you must note first.

The matter of risk vs reward

Traditionally, most debt funds have outperformed Fixed Deposits over the long term. However, its vital to understand that there are actually many different types of debt funds available, each of them having a unique risk profile. For example, GILT Funds, commonly perceived as risk-free due to the fact that they invest purely into government securities, actually carry the highest degree of “interest rate risk”, or the risk of price volatility that arises from movements in underlying interest rates. When interest rates in the economy fall, these GILT Funds will outperform heavily – however, if interest rates were to rise (as they are now), they could even give you a negative return! Similarly, there are some funds that aim to earn higher returns by investing in bonds that are lower rated and have higher coupons or yields. Though these bets can pay off richly, leading to double-digit returns, they can sometimes backfire too. The severe liquidity stresses many debt funds faced during the pandemic is a prime example.

How they differ from FD’s

Debt Funds differ from FD’s in many ways. Firstly, they do not give you a fixed rate of return. Unlike Bank FD’s, which lock in your interest pay out at a fixed rate (assuming your bank doesn’t go insolvent!) , your fund value can fluctuate in debt funds, based on market dynamics. Additionally, while FD’s provide returns purely in the form of interest pay outs, debt funds earn returns from interest (coupon) pay outs from their underlying bonds, as well as from capital gains that could arise if bond prices rise. Bond prices could rise when underlying interest rates fall, or if they are upgraded by a leading credit rating agency such as CRISIL or ICRA. Additionally, Debt Funds provide better exit options, allowing you to liquidate your money partially if the need arises. FD’s can only be ‘broken’ in totality, and this usually results in a penalty in the form of a reduced interest rate.

Should you go for FD's or Debt Funds?

Now that you’ve understood that Debt Funds are not “just like FD’s”, you’re in a better position to take an informed decision on them. FD’s are lower risk than debt funds, and less tax efficient too. Consequently, they usually provide returns that are slightly lower than those earned from debt funds. Your choice should depend upon your individual risk tolerance levels. If you’re investing into debt funds for the first time, choose those that have lower average maturities and higher credit profiles, and therefore carry lower risk. Consult with a professional Financial Advisor to understand which debt fund fits in best with your risk profile and investment objectives.