Are Debt Mutual Funds a Better Alternative to Fixed Deposits?

But do you think it is still the most appropriate investment option in the current scenario? Or does is it more sensible to opt for other investment options that could offer you potentially better returns and help achieve your goals?

These days, however, we are witnessing a slump in FDs with a marked transition toward debt mutual funds instead. As the interest rates on FDs have fallen to a record low, between 4-6%, many investors are looking at schemes of debt mutual funds as a viable alternative.

The Reserve Bank of India (RBI), in its bi-monthly monetary policy review in June, mentioned Repo and Reverse Repo Rate would remain unchanged at 4% and 3.35%, respectively. For FD investors who were expecting a change in key policy rates, the wait is indefinite.

On the upside, the debt category of MFs provides a wider range in short-term and long-term instruments and could be considered as an alternative investment option to bank FDs. Debt mutual funds invest in comparatively secured investment options such as corporate bonds, government securities, and money market instruments. These are considered relatively safer than other mutual funds categories such as equities and equity-oriented funds.

The Franklin Templeton Mutual Fund fiasco, the winding up six of its debt schemes due to liquidity crisis in bond market, raised investors' fears about other mutual fund debt schemes meeting similar circumstances and going belly-up after considering the allocation in moderate to low rated debt instruments.

Fortunately, the government lifted lockdown restrictions and planned various measures to infuse liquidity in the market to support economic growth. The debt market conditions have improved gradually and there has been a shift in investor sentiment.

Although experts predict that the interest rate on FDs is unlikely to decline any further; it may see a slight incline in the second half of FY22. What's interesting to note is the rise in fund in flows for April and May 2021 in mutual funds indicate a relatively higher positive investor sentiment towards mutual funds than FDs.

However, it is still a question for many investors whether to invest in debt mutual funds as an alternate to fixed deposits.

​Let us analyse these elements elucidated below, that may help us crystalize our viewpoint:

1. Risk Factors

When it comes to determining which investment option to pursue, risk factors are the most significant aspect to discuss.

Fixed Deposits are considered the safest with almost no-risk and are not exposed to market fluctuations. This means your investment is safeguarded against market risks and volatility. Whereas, mutual funds are subject to high risk because the investment is made in the financial markets. Debt funds are safer compared to equity funds since the underlying assets in debt funds primarily involve high rated fixed-income securities.

With the changing investment environment however, many investors are ready to take more risk for better returns that are also tax efficient.

Debt funds are not as volatile as equity funds, as the portfolios of debt funds don't contain equities, but contain debt instruments with a predefined maturity period and return on maturity or predefined regular interest/dividend income.

In terms of capital protection, the bank ensures capital safety for fixed deposits. If a lender goes bankrupt, investors' deposits including principal and interest are insured up to Rs 5 lakhs by DICGC, and hence FDs are considered risk-free investments. Debt funds are vulnerable to market fluctuations, and capital security is not guaranteed. Bear in mind there are two types of risk: interest rate risk and credit risk.

So debt funds are prone to higher risks as compared to bank FDs and thus, you need to assess your risk appetite before making investment decisions.

2. Return on Investment

Fixed deposits and debt funds provide different returns, just as they do in terms of risk. The returns on FDs vary depending on the term of the deposit, the type of depositor you are (regular individual or senior citizen), and the current market rates.

The repo rate is an important factor in determining the market rates and the rate of interest remains fixed for FDs for the entire investment period. As a result, FDs have a fixed maturity value. When market rates are low, FD interest rates typically fall as well, and vice versa. However, once your investment in FDs is locked in, it will continue to earn the same interest at a fixed rate for the entire duration of the term, regardless of whether market rates rise or fall.

Consequently, during periods of low-interest rates in the economy, debt funds often outperform fixed deposits by a significant percentage.

Debt funds, unlike FDs, do not promise pre-defined returns. Debt fund returns are market-linked, but historically they have outperformed FDs having similar maturities, according to past records.

Most of us use fixed deposit returns as a mental benchmark to gauge returns that can be made with the lowest risk and least effort. Notably, a fixed deposit technically has no interest rate risk and very low credit risk. Therefore, the closest proxy to fixed deposits via debt funds would be high credit quality rated funds with a majority AAA-exposure, low-interest-rate risk, and a modified duration of less than three years.

3. Liquidity

Fixed Deposits are not liquid because the invested amount remains locked in until maturity. Also, remember that with FDs, if you make a premature withdrawal, a penalty is charged to the investor. You earn a lower interest rate on the amount withdrawn from your fixed deposit.

Debt Funds, on the other hand, possess higher liquidity as early redemption is allowed with or without exit load depending on the type of fund. You can redeem your debt fund assets at the current NAV, which may be lower or higher than the amount you initially deposited. In some cases, exit load is applied on debt fund redemptions during the exit load period and it is levied on the redemption amount.

As debt funds can be redeemed at any time, they are more liquid than fixed deposits. In addition, debt funds consist of a sub-category called liquid funds that invest only in high-rated money market instruments that mature within 91 days. The most significant advantage of liquid funds is that they provide liquidity, which is an advantage fixed deposits don't have. Therefore, you can not only use liquid funds as an alternative to fixed deposits, but also as a means to accumulating an emergency corpus to fall back on at times of crisis.

Before investing, you should look at the exit load structure of any debt mutual funds and the penalty charges imposed by banks on premature withdrawal in fixed deposits.

4. Inflation effect

Everyone knows that inflation puts a damper on savings as it leads to loss of currency value. The policymakers use key policy rates to control inflation, Repo rate, Reverse Repo rate, and the overall interest rates on deposits and lending rates will vary accordingly.

The interest rate offered on FDs and the annual return or CAGR on debt fund should be close to the rate of inflation.

Fixed Deposits tend to remain unaffected by inflation as the interest rate is pre-decided. However, in case the rate of inflation exceeds the interest rate regime, the money invested in FDs would lose its purchasing power, i.e. the real return on your FD will turn negative. Thus, FDs are considered as inflation inefficient instruments.

For instance, if you have invested in an FD at 6% interest, and the inflation rate is 4%, the real return would be merely 2%.

On the other hand, debt mutual funds, despite the risk, have the potential to beat inflation and the capability to generate better returns. Debt funds may somewhat absorb the effect of the rise in inflation rate, as the fixed-return instruments may be traded in secondary markets.

5. Taxation

The interest earned from the FD is taxable depending on the tax slab of the individual whereas the taxation on debt mutual fund depends on the holding period.

The interest you earn from a fixed deposit is added to your net income and taxed according to your tax slab rate. Tax Deducted at Source (TDS) is levied on interest earned if it exceeds Rs 40000 for regular residents and Rs 50000 for senior citizens in a financial year. Investors can submit a 15G and 15H forms to inform that your income is not taxable or below tax slab and ensure the bank does not deduct TDS on your interest amount.

Debt funds are treated as capital assets, thus capital gain tax is applicable on these funds. In debt funds, there are short-term capital gains (STCG) for holding durations of up to three years and long-term capital gains (LTCG) for holding durations of more than three years.

If you redeem your debt funds before three years, they will be treated the same as a fixed deposit gain. This means it will be added to your taxable income and you will be subject to income tax as per the appropriate slab rate. Debt funds are taxed at 20% with indexation and 10% without indexation if held for more than three years under LTCG.

To conclude...

With Bank FDs offering lower interest rates at present, you can opt for FDs provided by financial companies, which tend to have a marginally higher rate than traditional scheduled, commercial banks. Also, reinvesting your interest earnings can help you harness the power of compounding, multiplying your cumulative returns.

When you think of considering debt mutual funds as an alternate for your FDs, you could possibly earn higher returns if you invest a portion of your savings in debt mutual funds. In addition to this, Debt funds offer either a SIP mode with small investment amount or a lump sum investment like FDs.

Due to market fluctuations and interest rate volatility, short-term debt funds could prove to be more suitable than fixed deposits, as long duration debt schemes are prone to higher interest rate risk.

If you are seeking for an alternate for FDs, make informed decisions after considering your suitability based on investment goals, risk profile, investment horizon, and tax slab. Debt funds consisting of AAA-rated instruments in the portfolio for short-term may be considered as an alternative for your low interest rate Fixed Deposits.

If you are a risk-averse investor, or heading towards retirement, and prefer to safeguard your capital, opt for bank fixed deposits with the maximum interest rate option and ensure to choose the bank carefully.

PS: If you wish to select worthy mutual fund schemes, I recommend that you subscribe to PersonalFN's unbiased premium research service, FundSelect.

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Warm Regards,
Mitali Dhoke
Jr. Research Analyst

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