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Amidst falling interest rates, should investors choose debt funds over fixed deposits?

Debt funds generate extra returns by taking additional risks, which is not the case with fixed deposits

November 05, 2020 / 09:41 AM IST

Dev Ashish

The interest rates on bank fixed deposits (FDs) are at multi-year lows. And, it looks like the low-rate scenario will continue for a bit longer than expected. This is definitely bad news for those who had a major part of their savings parked in FDs.

As a result, FD lovers are looking for fixed-income alternatives. One such alternative is a debt fund.

In the debate of debt fund vs. fixed deposits, there are strong pros and cons on either side. And to be fair, both can have their places in an investor’s portfolio. But for this discussion, we look at how debt funds are turning out to be suitable alternatives to fixed deposits in the current low-rate environment.

Let’s compare the two from the following vantage points:

Close

-Returns

-Taxation

-Liquidity

-Safety

Returns

In general, on the basis of historical data on average returns, debt funds have delivered better returns than bank FDs. But let’s not forget that debt funds generate those additional returns by taking additional risks, which is not the case with fixed deposits. So, it’s natural for them to compensate with comparatively higher returns. And debt fund investors take interest rate as well as credit risks for these high returns. But given the volatility of debt fund returns, there is one other thing to take note of. It’s not necessary that debt funds will beat FDs every year. It’s just that the average returns over a period of a few years are expected to be better than those from FDs.

Taxation

On this factor, debt funds sprint ahead of bank deposits. FD interest is taxable and is added to the deposit holder’s income and taxed according to the applicable slab. For those in the highest 30 percent tax slab, the tax takes away a large part of the FD interest income.

But debt funds have favorable taxation once you hold them for more than three years.

If held for less than three years, the capital gains from the debt fund are taxed in a like FDs. However if held for more than three years (or 36 months), the capital gains are taxed at 20 percent with indexation. Indexation lowers overall tax liability by inflating the purchase cost (investment amount), thereby reducing the effective capital gains.

Liquidity

Unlike fixed deposits, you can withdraw or redeem your debt fund units whenever you want to. For practical purposes, there is no lock-in and exit loads are also negligible once you hold them for more than a few months (or a year). Fixed Deposits, on the other hand, are locked in for the chosen tenure. You can still liquidate them prematurely. But you will be penalized if you withdraw before the maturity date.

And you can withdraw any amount you want from your debt funds. But in FDs, the whole FD has to be liquidated even when you need a small amount. For example, let’s say you have Rs 1 lakh parked in an FD and Rs 1 lakh in a debt fund. If you need Rs 20,000, then you can easily withdraw it from the debt fund. The remaining Rs 80,000 remains invested. In FDs, you will have to break the entire Rs 1 lakh FD and then take Rs 20,000 from it. So, on the liquidity front, debt funds do better than fixed deposits.

Safety

FDs are pretty safe. And for all practical purposes, even risk-free. Debt funds are not risk-free. Think about it. If some product delivers higher than risk-free returns, then it’s obvious that it is taking some risk. Isn't it?

It is therefore important to have the right expectations from debt funds. These funds take interest rate and credit risks to generate higher returns. Most of the time, these risks work out in the investor’s favour. But every once in a while, they don’t.

So, what do you do?

Debt funds in general will deliver better post-tax returns. But there are risks and these should be understood well when pitching debt funds as alternatives to fixed deposits.

For most investors looking at debt funds space, it’s best to stick to high-quality and low duration funds such as Liquid, Ultra Short Duration, Low Duration and Short Duration Funds. If you stick to these categories, then you are limiting the interest rate risk that comes with higher duration funds. And if you only pick funds from these categories that have high-quality underlying papers, then you are also limiting the credit risk to an extent. And controlling these two risks is very important when investing on the debt side of the portfolio.

For most low-risk investors, bank deposits have been a popular option. But with falling rates, debt funds are becoming viable alternatives.

(The writer is the founder of StableInvestor.com)
first published: Nov 5, 2020 09:41 am

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