Debt Funds vs FD - Which Is The Best Investment Option?

Throughout the past decades, bank fixed deposits have remained as the first port of call for generations of risk averse investors. However, the growing awareness regarding alternate investment options and their potentially higher returns and other features have led many investors to turn towards them, especially debt mutual funds. This makes it imperative to weigh these two investment instruments and understand their varying characteristics to decide the optimal choice for one¡¯s financial needs. But first, let¡¯s understand what debt funds and bank fixed deposits are:

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What are Debt Funds?

Debt funds are a type of mutual funds that invest in fixed income securities such as corporate bonds, treasury bills, commercial papers, government securities, and numerous other money market instruments. Each of these instruments involve a pre-decided maturity date as well as interest rate which the investor can earn on maturity. As the returns of these securities are generally not impacted by the market fluctuations, they are much less volatile than equities, thereby making debt securities a suitable investment option for risk averse investors.

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What are Bank FDs?

A fixed deposit (FD) is a popular investment vehicle that banks offer to customers to promote saving and wealth creation. Through investment in FD, one can invest a certain amount for a fixed period at a predetermined rate of interest. The rate of interest varies bank to bank and tenure to tenure, but remains fixed for the entire chosen tenure of the FD. Upon maturity, you are entitled to receive the invested principal along with compounded interest.

Debt Funds vs FD

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1. 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 5 lakh for both interest and principal in case of bank failure. This insurance cover extends also to other forms of bank deposits such as savings, current and recurring. In case you hold deposit accounts in more than one bank, Rs. 5 lakh cover would apply separately to each bank.

Debt funds on the other hand, do not offer any capital protection. As the underlying securities being traded in debt markets are vulnerable to market¡¯s fluctuations, they can be exposed to capital erosion. Primarily, the two main risks faced by debt fund investors are interest rate risk and credit risk. Interest rate risk is when the investment in underlying debt funds gets impacted by the unexpected changes in the RBI¡¯s interest rate. One can mitigate this risk by opting for short term debt funds having lower maturity, such as liquid funds or ultra-short term funds.

As far as the credit risk of debt funds is concerned, it refers to the risk arising due to a default in interest or principal repayment by the underlying securities¡¯ issuers. This risk can be minimized by opting for the debt funds that invest in instruments having high credit rating, as they involve lower risk of default.

2. Returns

FD interest rates remain fixed till its maturity tenure, irrespective of the changes in the FD¡¯s card rate during the tenure. For instance, if you have opened an FD for 3 years tenure at the card rate depicting 7% p.a. Interest rate, then that interest rate will stay the same for the entire tenure of 3 years.

On the other hand, returns generated by debt funds primarily depend on the interest income earned and the capital gains garnered from the underlying securities. Credit ratings of underlying securities, assigned by agencies like CRISIL, CARE and ICRA, also play a crucial role in deciding the interest income. The low rated securities tend to usually yield higher interest income but involve larger risk, vis-a-vis the high rated ones which involve lower risk. Therefore, before choosing between long term and short-term debt funds, carefully analyse the current interest rate regime and credit rating of the underlying securities.

*For debt funds, the range is category average of all 16 categories.. Debt fund returns as on 22.09.2021 (regular plans) sourced from valueresearch. For Fd, Indicative broad range of FD rates currently offered by largest banks like SBI,HDFC,ICICI,Axis etc and FD rates offered by SFBs.

As visible from the above mentioned data, the returns of debt funds tend to be on the higher side as the tenure goes longer, whereas for short term tenure like 3 months, current bank FD rates tend to outperform debt fund returns. However,basing your decision on this, remember that debt funds are market linked investment instruments,and these returns are indicative of past performances and thus, do not guarantee similar returns in future. Whereas bank FD rates and their mechanism is simple and straightforward, the applicable rates would apply on your FD and remain the same till the maturity.

3. Taxation

For FD investors, tax liability does not end with TDS deduction done by banks. Interest income from FDs, even that of five year tax saving FDs, are included in your annual income and taxed in accordance with your tax slab. Remember that, the difference between the actual tax liability and TDS amount deducted gets adjusted at the time of filing income tax returns. Hence, depositors must always factor in their tax slab while calculating post tax return from their FDs. Doing so will help in making a better comparison between their fixed deposit returns and their alternative investment instruments, such as debt mutual funds.

For debt funds, the returns booked on redeeming your investment within 3 years are considered as short-term capital gains, which is included in your annual income and taxed in accordance with your income tax slab. Whereas, the returns booked on investments after 3 years are considered as long-term capital gains and get taxed at 20% with indexation benefits.

4. Premature withdrawal

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

Moreover, to further provide impetus to liquidity for FD investors, most banks offer loans against FD, usually in the form of overdraft facility. The borrower continues to earn interest on the pledged FDs during the loan tenure and can withdraw upto the sanctioned amount from their overdraft account and repay it as per his/her repayment capacity.

Whereas in case of debt mutual funds, only the fixed maturity plan (FMP) restricts redemption while other categories allow withdrawal by paying a minimal exit load if redeemed before a predetermined period. However, ultra short funds, liquid funds and most short-duration debt funds currently do not levy any exit load. Thus, the presence of high degree of liquidity is what makes these funds a prudent option for parking money for emergency fund and short-term goals.

5. Cost of Investment

For both the purposes of opening and maintaining FDs, banks do not charge any fee. Whereas for operating your debt mutual fund schemes, mutual fund houses charge multiple fees such as advisory and management fees, audit and legal fees, sales and agent commissions, marketing and selling expenses etc. These charges are expressed in the form of total expense ratio (TER). This ratio is derived by dividing the fund¡¯s total expenses by the total assets of the fund. A smart way for investors to mitigate this expense is by opting for direct plans of debt funds, instead of their regular counterparts, as the TER of direct plans is usually lower than the regular plans.

Summing it up

In terms of capital protection, investment cost and income certainty, FDs hold an upper hand over debt mutual funds. When it comes to liquidity, the decision should be taken after taking into consideration the rules/conditions pertaining to the held FD/debt fund. While most FDs allow premature withdrawal but levy a penalty for the same, some debt funds too tend to levy exit load on redemption before pre-set timelines. As far as post tax returns are concerned, debt funds edge past bank FDs, as the former¡¯s returns are higher than those of bank FDs for investors falling in the higher tax slabs and those with investment horizons exceeding 3 years.

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