Here is a brief comparison between debt funds and fixed deposits and how they fare against each other. (Photo: PTI/File)
Keeping fixed deposits in banks remains a popular choice of investment for most Indian households. A large section of equity fund investors also use bank fixed deposits to save for their short- and mid-term financial goals. However, falling returns from fixed deposits and growing awareness about alternate sources have led to many considering debt mutual funds for earning higher returns.
Here is a brief comparison between debt funds and fixed deposits and how they fare against each other:
Capital protection: Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of RBI, insures each bank depositor for up to Rs 1 lakh in the event of bank failure. The cover extends to savings accounts, fixed deposits, current account and recurring deposits and includes both principal and interest components. If you have deposits in more than one bank, the Rs 1 lakh cover would apply to each of them separately. Deposits exceeding the Rs 1 lakh coverage limit remain at risk, though low.
Debt funds, on the other hand, do not offer capital protection. As their underlying instruments are traded in debt markets, they too are susceptible to capital erosion. Increases in policy rates and default(s) by one or more of their constituent securities can also increase the downside risk of a debt fund. However, one can mitigate these risks by choosing debt funds on the basis of the credit risk and maturity profiles of their underlying securities. For example, as liquid and ultra-short term funds have very short maturity profile, they carry very negligible risk from interest rate increases. Similarly, debt funds investing in securities with higher ratings like AAA, AA carry very low default risk than others.
Returns certainty: Bank fixed deposits offer highest form of income certainty among all investment products. The interest rate booked at the time of opening a bank FD remains in effect till its maturity irrespective of the increase or decrease in the FD rates by the bank itself. For example, if you open a bank FD at 7.5% p.a. of 3 years tenure, the bank will continue to pay the same rate of interest till the end of the 3-years tenure, irrespective of the changes in the interest rate it makes during this period.
The returns generated by debt funds would depend on the interest income and capital gains generated from their underlying securities. A debt fund investing in securities with lower credit ratings would earn higher interest income as such securities have higher coupon rates (interest rates) than the highly rated ones. Similarly, any change in the credit ratings of their underlying securities would affect the funds’ returns. The price of a low-rated debt instrument would increase on receiving a credit rating upgrade while the opposite happens in case of rating downgrades. Opt for ultra-short term and short-term debt funds for earning higher returns than fixed deposit at very low credit and interest rate risks.
Taxation of returns: The interest earned from your bank fixed deposits is added to your total income and taxed according to your tax slab. In case of debt funds, the gains made on redeeming your investment within 36 months is treated as short-term capital gains (STCG) and taxed according to your tax slabs. Gains realised after 3 years are treated as long term capital gains (LTCG) and taxed at 20% with indexation benefit. Thus, for someone falling under 30% tax slabs with investment horizon of more than 3 years, debt funds will be more tax-efficient than fixed deposits.
Liquidity: Banks do not allow premature withdrawal of tax saving FDs as they come with a lock-in period of 5 years. While premature withdrawals are allowed in case of other bank FDs, they discourage it by charging penal rates. After the adjustment of penal rates, the final interest rate paid on prematurely closed FD becomes much lower than the original booked interest rate.
Among all debt fund categories, only Fixed Maturity Plans come with redemption restrictions. Although many debt funds charge exit loads on redeeming within pre-specified period, such loads usually range between 0.25-1% of the redeemed amount while the pre-specified period ranges between 15 days and 6 months. Liquid, ultra-short term and short-term debt funds generally do not charge any exit loads. This makes them a strong option for parking money for short-term goals and emergency fund.
Cost of Investment: Banks do not charge any fee for opening or maintaining bank FDs. However, mutual fund houses charge various fees for operating their debt schemes, such as fund management fee, registrar and transfer Agents’ fee, transaction fee, distribution fee, etc. These charges are aggregated and expressed as expense ratio --- the ratio of annual operating expenses of a scheme and its average daily net assets. Opt for direct plans of debt funds as their expense ratios can be up to 1% lower than their regular counter-parts.
- By Naveen Kukreja – CEO & Co-founder, Paisabazaar.com