Debt Mutual Funds or Fixed Deposits :Which One Deserves Your Savings?

The majority of people want to see their cash and don't want to lose a night's sleep in the process. It is for this reason that conservative investors continue to follow two types of investment: debt mutual funds and bank fixed deposits. On the face of it, both are “safer” investments in a portfolio, but have very different characteristics when examined. One provides flexibility and market related growth, the other provides certainty and simplicity. This guide gives you an understanding of what each is, where each excels and how to determine based on your own goals, time horizon and tax situation.

What Is a Debt Mutual Fund?

Debt mutual funds are funds that bring together the money of a large number of investors and use it to buy fixed-income securities like government bonds, corporate bonds, treasury bills and money-market instruments. The fund receives interest on these investments and the price of the fund (NAV) also fluctuates based on fluctuations in bond prices.

There are no guarantees of returns, as those prices are interest rate sensitive and depend on the credit quality of the issuers. They may be consistent for a long time and fall at times. You are offered professional management, diversifying your investment in a variety of issuers and are able to start small, in many cases with a SIP of ₹500.

Popular Debt Fund Categories

Debt funds are not all alike. Liquid and overnight funds are good for parking money that can be kept for days or weeks. Ultra-short and short-duration funds are ideal for investors with a short-term outlook, ranging from a few months to a few years. Corporate bond and gilt funds invest in longer-dated securities, and are more sensitive to interest rates. Target-maturity funds are bonds that are meant to be held until a certain date, giving the investor a more predictable return should he or she hold the bonds until then.

Risks to Know

There are two risks that are most important. Interest-rate risk is the potential for NAV to decline in an increase in interest rates, particularly in longer duration funds. Credit Risk: refers to the possibility that an issuer will default or be late in making payments. It is good practice to carry out some fundamental analysis on a fund before investing.Before investing, it is best practice to do some fundamental analysis on a fund, including checking on the duration and the quality of the fund's portfolio.

What Is a Fixed Deposit?

A fixed deposit (FD) is an amount of money that you deposit with a bank or NBFC for a specific time period, typically ranging from a few days to 10 years. The interest rate will be fixed at the time of booking the deposit and you will know what your maturity value will be from the first day. The payments are possible as either periodic interest (monthly, quarterly or yearly) or as cumulative interest paid at maturity.

Typically, early withdrawal is permitted, with a penal rate and interest rate reduction. The deposit insurance scheme by DICGC provides an additional safety net to bank deposits, insuring them against losses up to ₹5 lakh per depositor per bank. Please always check the current limit and your bank's conditions prior to booking.

How FD Interest Is Taxed

If you have FD, then your interest is included in your income and taxed at your slab rate. The banks withhold TDS only when the interest amount crosses the prescribed limit, but if eligible investors are able to submit Form 15G or 15H then they will not be liable for TDS. This is particularly true if you're in a higher tax bracket, as the post-tax rate can be significantly below the nominal one.

Returns, Risk, Liquidity and Tax Compared

When investors weigh debt fund vs fd, four factors usually decide the outcome: how predictable the returns are, how much risk you can accept, how quickly you can exit, and how much you keep after tax. The table gives a quick view, and the sections below explain it.

Returns and Risk

When interest rates decline, a debt fund can provide good returns as the value of the pre-existing bonds will appreciate. It may also include temporary declines during increasing rates and/or when an issuer is downgraded. That's what an FD can do. Rates are fixed when you book, making planning simple, but you might miss out on the increase in rates that may occur after you're booked.

Liquidity and Tenure

The open-ended debt funds are typically funded with no fixed tenure, which can be redeemed as per needs and some funds impose exit load on redemption of funds. FDs tie up your money for the term you pay and if you break one prematurely, you have to pay the interest.

Taxation

Mutual fund tax law has undergone some changes in the past few years. The tax benefit of most debt funds is now given on a slab rate basis, similar to FD, which has reduced the tax benefit to an extent. There is always a chance for the rules to be updated again, so consult the most up-to-date rules or a tax professional before making a decision.

Which One Suits Your Financial Goal?

A debt fund may suit you if:

• You can move the timing of your contribution around, or you might need to deposit and/or take out funds in increments.

• An allowance for slight changes in value will be accepted.

• You wish to park extra money, create an emergency corpus or use a SIP or STP

• You'd like to match a fund category with the exact time frame you're looking for.

An FD may suit you if:

• You must have an estimated amount at a specific time – e.g. a school fee or a down payment

• You like moderate to low volatility in NAV.

• You are a retiree and would like regular and predictable cash flow.

• You're looking for simplicity, without a fund selection requirement involved.

It's always best to use both. Have a basic safety bucket while having debt funds for medium term flexible funds. You can use sites such as thetopstockbroker to find and compare products, and come up with a plan for how to allocate them to fit your objectives.

Common Mistakes to Avoid

• Chasing past returns. The past year hasn't necessarily predicted the future year of a fund.

• Mismatching duration. Long-duration funds are not suitable for purposes that have a time horizon of less than one year.

• Ignoring credit quality. It is true that higher yield could be attributed to weaker issuers.

• Advantage of ignoring costs and tax. All of these exit loads, expense ratios and slab-rate tax take away what you have.

• Playing a whole instrument set. Playing only a single instrument. A diversification of both options will minimize the problem of regret.

Final Thoughts

Debt funds are flexible, efficient and have minimal entry amounts, whereas FDs are sure, simple and have a fixed rate. There is no one right or wrong. The best choice for you will depend on your objectives, the time frame you're willing to commit to investing, and the level of volatility you are willing to tolerate. Begin with the most basic of the rates, not the highest.

Mutual fund investments are subject to market risks. Read all scheme-related documents carefully. This content is for education and is not investment advice.