Debt funds vs fixed deposits, which one is right for you

Bank fixed deposit has been a preferable investment choice for generations of risk averse investors. However, growing awareness regarding alternate investment options have led many investors to turn towards debt mutual funds as it provides higher returns and liquidity than bank FDs. Here is a comparison between two revealing how debt funds fare against fixed deposits:

Capital protection

Protection cover guaranteed by the Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of RBI makes FDs one of the safest instruments for parking investible surplus. Each bank depositor is insured up to a maximum of 1 lakh for both interest and principal in case of bank failure. This coverage extends to other bank deposits such as savings, current and recurring. If you open deposit accounts in more than one bank, Rs. 1 lakh cover would apply separately to the deposits in each bank.

Debt funds do not offer any capital protection. Since their underlying securities are traded in debt markets, they may be vulnerable to capital erosion. Interest rate and credit risk are 2 main risks faced by debt fund investors. Interest rate risk is when the investment in underlying debt funds suffers due to unexpected changes in the Central Bank’s interest rate. This risk can be seen in all kinds of debt funds at varying levels and is higher in debt funds having longer maturity profile like long duration fund, dynamic bond, medium duration fund, medium to long duration fund and gilt funds. You can mitigate the risk by choosing debt funds having lower maturity profile like ultra-short term and liquid fund.

Credit risk of a debt fund is the risk due to default in interest or principal repayment by issuers of its underlying securities. The risk can be minimised by choosing the debt funds that invest in high credit rated instruments. 

Returns

The rate of interest for FDs is fixed till its maturity irrespective of the changes in its card rate. For instance, if you open an FD of 5 years tenure at 7.5% p.a., the interest rate will stay same till the end of the 5 years tenure.

On the other hand, returns generated by debt funds depends on the interest income earned and the capital gains garnered on trading underlying securities. Credit ratings of underlying securities also play a crucial role in deciding the interest income. Low rated securities earn higher interest income in comparison to the high rated ones as they pay higher coupon rates.

On receiving credit rating upgrade the price of low rated bonds increase, while on receiving credit rating downgrade the price of low rated bonds decrease. Therefore, before choosing between long term and short-term debt funds, carefully analyse current interest rate regime and credit rating of the underlying securities.

Taxation

Returns from FDs is included to your annual income and taxed in accordance to your tax slab.

For debt funds, the returns booked on redeeming your investment within 3 years is considered as short-term capital gains, which is included to your annual income and taxed in accordance to your tax slab. The returns booked on investments after 3 years is considered as long-term capital gains and is taxed at 20% with indexation benefits. Debt fund is likely to be more tax efficient than FDs for those falling under higher tax brackets with an investment horizon of over 3 years.

Premature withdrawal

Usually banks charge penalty of up to 1% on pre-mature withdrawal of FDs. This rate is deducted from effective rate of interest, which is either at the contracted FD rate or original card rate for the period for which the FD has been into effect, whichever is lower.

In debt mutual fund, only fixed maturity plan restricts redemption while others allow withdrawal by paying an exit load of up to 2% if redeemed before pre-determined period. However, liquid funds, ultra-short and most short-duration funds do not charge any exit load. High liquidity makes these funds a prudent option for parking money for emergency fund and short-term goals.

Cost of Investment

For opening and maintaining FDs, banks do not charge any fee. However, for operating your debt schemes, mutual fund houses charge numerous fees such as advisory and management fees, audit and legal fees, sales and agent commissions, marketing and selling expenses etc. These charges are expressed as total expense ratio. This is the ratio of annual operating expenses as a percentage and its average daily net assets. You can mitigate this expense by opting for direct plans of debt funds as TER of the direct plans is usually up to 1% lower than the regular plans.

(Author Naveen Kukreja is CEO and Co-founder, Paisabazaar.com)