Debt mutual funds vs. Fixed Deposits: How do they fare against each other?

How debt funds fare against fixed deposits

Capital protection: Bank FDs can be rightly considered as one of the safest avenues for parking your surpluses. The reason is that Deposit Insurance and Credit Guarantee Corporation (DICGC), an RBI subsidiary, guarantees all bank deposits of up to Rs 1 lakh in the event of your bank’s failure. The coverage extends to all types of bank deposits, including fixed, savings, current and recurring deposits. Conversely, it also means that your bank deposits with a bank exceeding Rs 1 lakh coverage limit carries similar risk as with other financial instruments. Remember, the insurance coverage of up to Rs 1 lakh includes both the principal and interest components. Thus, if you have deposits with different banks, then the Rs 1 lakh insurance coverage would separately apply to each banks.

Debt funds do not offer capital protection. As their underlying securities are traded in debt markets, they too carry market risk as with any other market-linked investments. Usually, debt funds are exposed to two major risks — interest rate risk and credit risk. Interest rate risk refers to the downside risk of a debt fund caused by the changes in the central bank’s interest rates. This risk is present in all types of debt funds in varying degrees, depending on the maturity of their underlying securities. For example, debt funds with longer maturity profile like gilt funds carry high interest rate risk while those with lowest maturity profile like liquid and ultra-short term funds carry negligible interest rate risk.

Credit risk of a debt fund refers to the risk of default in principal or interest repayments by the issuers of its underlying securities. This risk can be deduced by going through the credit ratings of their underlying securities. Debt instruments with AAA rating are considered of the highest quality followed by those with AA, A, BBB, BB and so on. Thus funds with higher concentration of top-rated securities carry the lowest credit risk.

Certainty of rate of returns: Bank FDs pay fixed rate of interests till the end of their tenures irrespective of the increase or decrease in their own card rates during the interim period. For example, if you open an FD of 3 years tenure @ 7% p.a., the rate of interest will remain the same till the completion of the 3-years tenure. Thus, fixed deposits offer an unparalleled certainty in terms of rate of returns. Currently, FD interest rates range of major public sector and private sector banks range between 3.5% p.a. to 7.5% p.a., depending on their FD tenures.

Debt funds generate returns for you through a combination of interest income earned from their underlying securities and the capital gains realised on trading those securities in the debt markets. The credit ratings of their underlying securities also play a major role in determining their interest income. A fund investing in low-rated securities would earn higher interest income as such securities pay higher coupon rates (interest rate committed by debt securities) to their investors.

The capital appreciation of the underlying securities depends on their credit rating upgrades or downgrades and the changes in RBI’s interest rates. The price of a low-rated bond increases on receiving a rating upgrade from credit rating agencies. The opposite happens after rating downgrades. As far as the effects of broader interest rate movements are concerned, rate cuts increase the NAV of debt funds while rate hike does the opposite. This is because the prices of the debt securities increase post-rate cut as their coupon rates would be higher than the new issues of debt securities post rate-cut. Similarly, rate hikes decrease the prices of their existing securities as future debt issues will offer higher coupon rates. However, the degree of increase or decrease of the fund’s NAV also depends on the maturity of their constituent securities. For example, ultra short term and short term debt funds are least affected by interest rate changes due to their shorter maturity profile whereas NAVs of long term debt funds register steeper declines and increases after rate hike and rate cut, respectively. Thus, undertake a careful analysis of the current interest rate regime and the credit rating of the funds’ underlying securities while choosing between short-term and long-term debt funds.

Liquidity: Banks penalise premature withdrawal of FDs by paying lower interest rate than the original booked interest rate. Premature withdrawal is however not allowed in tax saving fixed deposits as they have a lock-in period of 5 years. Most banks currently deduct 1% from the original booked rate or 1% from the original card rate applicable for the period for which the FD has been in force, whichever is lower. These may adversely impact your FD’s effective rate of return in case of pre-mature withdrawal during emergencies.

Debt mutual funds, other than Fixed Maturity Plans, do not restrict redemptions. However, many funds charge exit loads, ranging from 0.25–1% of the redeemed amount, if they are redeemed within a pre-specified period. Such periods can range anywhere from 15 days to 6 months. Ultra-short term and many short-term funds do not charge exit loads. Such debt funds will suit best to park your emergency fund.

Investment Costs: Banks do not charge consumers for opening or maintaining their FDs. However, fund houses  charge their investors for operating their debt schemes in the form of annual recurring expenses. This includes investment management fee, advisory Fee, registrar and transfer Agents’ fee, transaction fee and other marketing and selling costs. However, SEBI has placed an upper cap of 2.25% p.a. on annual recurring charges.

Tax treatment: The interest earned from your bank fixed deposits is added to your annual income for taxation purposes. Hence, the tax rate on interest earned will depend on your tax slab. For example, if your annual income after including interest earned from your fixed deposit falls within the 30% tax bracket, the interest component will attract 30% income tax.

In case of debt funds, the gains made from redeeming them are treated as capital gains and are taxed on the basis of the period of your investment. Gains realised within 3 years are treated as short-term capital gains, which are then added to your annual income and taxed according to your applicable IT slabs.  Gains realised after 3 years of investment are treated as long term capital gains and taxed at 20% with indexation benefit. The indexation benefit factors in the inflation rate while calculating the tax on your gains. Thus, even if a bank FD and a debt fund generate same rate of return, the debt fund will still generate higher post-tax return, provided you come under 20% or 30% tax bracket and your investment horizon is more than 3 years.

Conclusion

Debt funds clearly outscore bank FDs in terms of returns, liquidity and tax treatment. While highest card rate offered by major banks does not exceed 7.5% p.a., short-term debt funds (considered as the best alternative to bank FDs) as a category have generated annualized returns of around 8.9% p.a. over the last 1-year and 3-years periods. Bank FDs outscore debt mutual funds only in terms of capital protection and certainty of returns. However, if selected wisely, even these risks can be mitigated to a large extent.

Just like in case of other mutual fund investments, debt fund selection requires a close analysis of their past performances and investment objectives along with your own risk appetite and time horizon. Opt for ultra-short term funds if your investment horizon is less than 12 months. Go for short-term debt funds if you have an investment horizon of 1–3 years. For investment horizons between 3–5 years, invest in equity-oriented hybrid funds. If your objective is to save tax under Section 80C, invest in Equity-Linked Saving Schemes (ELSS) instead of tax saving FDs. ELSS schemes have a lock-in period of just 3 years, lowest among all Section 80C options, while their maturity amount and returns are entirely tax-free. Moreover, their returns too outscore tax saving FDs by a wide-margin. For example, ELSS funds as a category have generated annualised returns of about 16% and 20% over the last 3-year and 5-year period.

To end it, always use SIPs to ensure disciplined investment in debt mutual funds. Estimate the corpus required to achieve your financial goals and use SIP calculators to determine the monthly investment required to achieve those goals. This will ensure financial discipline without locking your hard-earned money for sub-optimal returns.