Fixed deposits have always been close to heart investment choice for conservative investors. The reasons do justify their favourability. Returns on FDs are appealing, and they are prominently safe and secure. Further, you could easily open an account and invest in your friendly neighborhood bank itself. FDs were quite popular until the charisma of mutual funds spread predominantly over the last few years. Falling interest rates led to lower returns on FDs, and simultaneously, people started paying attention to the benefits of debt mutual funds. Let’s have a look at how debt funds turned out to be better than FDs.
Debt Funds vs. Fixed Deposits
A brief point comparison is drawn between debt funds and fixed deposits in the following table.
|Area||Fixed Deposits||Debt Funds|
|Returns||Lower Returns||Higher Returns|
|Risk||Almost Risk-free||Market Risk|
|Liquidity||Less Liquid||Highly Liquid|
|Tax||Not Efficient||Very Efficient|
|Flexible||Relatively Rigid||Highly Flexible|
- In terms of interest rate
The major difference is that debt funds serve its investors a lot of flexibility and options. FDs return rate has dropped to 6.6-7.5% p.a. from 8-8.5% p.a. while debt funds still give returns over 9% on an average. FDs are fully secured, but the interest is taxable at your peak rate of tax which doesn’t seem like a good idea. Besides, FDs tend to pay only the interest rate that is committed. On the contrary, debt funds benefit from falling interest rates as they experience NAV appreciation when lowered rates. This benefit is passed on to investors giving them higher interest rates on their investments.
- In terms of tax efficiency
Another significant difference between debt funds and fixed deposits is taxation. Returns from FDs are interest income and are added to your normal income. As most of the investors come under a 30% tax bracket, this takes away a large part of their returns. Now banks also deduct TDS on the interest income from FDs. For debt funds kept for 36 months or less, tax rates are the same. If kept longer than 36 months, returns are classified as long-term capital gains and are taxed at 20% with indexation.
- In terms of liquidity
When talking about liquidity, open-ended debt funds proceeds are credited within a period of 2-3 working days depending on the factors such as whether an Electronic Clearing Services (ECS) is registered. FDs are also credited at one or 2-day notice, but if you are redeeming them before the maturity date, you will have to pay a penalty. The banks will penalize this premature withdrawal by paying lower interest rates than committed. Also, early withdrawal is not even allowed in tax-saving FDs as they have a lock-in period of 5 years.
Debt funds do not restrict redemption other than Fixed Maturity Plans. However, they have exit loads or charges that are levied when you redeem within a pre-specified period. This period can range from 15 days to 6 months, and around 0.25-1% of the redeemed amount is charged. Ultra short-term and many short-term funds do not charge exit loads. Such debt funds are suited best to park your emergency fund.
- In terms of flexibility and transparency
Again debt funds are going to score in this area. In debt funds, you have a choice that you can switch, based on your observation of market conditions. But when you invest in FDs, you won’t be able to track where your money is invested or being used. When it comes to debt funds, you have a transparent portfolio in front of you each month and the NAV daily. This feature is indeed a savage for any investor. Also, SIP funds can be tagged to goals.
- In terms of risk
If you are going to judge based on the risk involved in both types of investments, it is evident that FDs lead this one. However, debt funds are the closest to conventional bank deposits in terms of risk. Their main goal is to give investors a steady income throughout the investment tenure. So, if a time horizon in line with that of debt funds is chosen, the risks are minimalized.
Debt funds outscore bank FDs in terms of returns, liquidity, investment options, transparency, and tax treatment. While FDs outscore debt funds in terms of risk. If debt funds are selected wisely, even these risks can be mitigated to a large extent.
As investors, we need to remember that while making an investment, there is always some risk involved. It is undeniable that risk keeps changing, and not doing anything about this may only make it worse.
Also, before investing in debt funds, do your homework. Performance track record along with scheme-specific attributes, portfolio credit quality, fund manager track record, and expense ratios do matter.