Debt vs. Fixed Deposit Mutual Funds: Where Should I Invest?
A look at term deposits and debt mutual funds
You invest a lump sum of money in a Fixed Deposit Account (FD) for a fixed term at a fixed interest rate that is unaffected by market fluctuations. Although investing in fixed deposits for a period of 5 years will give you tax advantages, these are the most preferred investment options for seniors as they get additional interest rates compared to the general public under the form of regular income. In terms of risk, debt funds are riskier than traditional FDs. The fundamental objective of a debt fund is to provide a constant return to investors throughout the investment period. Debt funds are safer than equity funds because the underlying assets of debt funds are typically bonds, government securities, money market instruments, commercial papers, and others. debt securities. However, debt-grade MFs offer a wider range of options for maintaining short-term investments and can be used as a substitute for bank FDs.
When it comes to determining which investment option to choose, risk is probably the most important aspect to discuss. FDs offer investors guaranteed returns, and the specified interest you get doesn’t vary with the ups and downs of the market. If you want guaranteed risk-free returns, bank term deposits are a good option. If you want better returns at the cost of higher risk, you may want to consider investing in funds of appropriate mutual fund categories that match your goals and tolerance for risk. By comparing debt funds to FDs in terms of risk, the bank guarantees security of capital as your deposits are insured by DICGC. If a lender goes bankrupt, investors’ deposits – including principal and interest – are insured up to Rs 5 lakhs by DICGC, and therefore FDs are considered risk-free investments. Loan funds are vulnerable to market fluctuations and safety of principal is not guaranteed. In a debt fund, there are two types of risk: interest rate risk and credit risk. Interest rate risk is lower in debt funds that invest primarily in money market instruments, but interest rate risk is higher in long term Gilt funds. Credit risk is determined by the credit ratings of the underlying securities. The interest rate on a fixed deposit is predetermined for the term of the deposit. Whereas the returns of a debt fund can fluctuate with changes in interest rates. If interest rates rise, the returns of the securities in your portfolio fall, resulting in a drop in net asset values (NAVs) and, therefore, lower returns. If interest rates fall, on the other hand, NAVs will rise.
Fixed deposits and debt funds offer different returns, just as they do in terms of risk. FD rates of return vary depending on the length of the deposit, what type of depositor you are, and current market rates. When market rates are low, FD interest rates also fall, and vice versa. The repo rate is an important factor in determining the market rate. However, once locked in, your investment will continue to earn the same interest at a fixed rate for the duration of the term whether market rates rise or fall. Loan funds, unlike FDs, do not promise guaranteed returns. Loan fund returns are market-linked, but historically they have outperformed DFs with similar maturities, according to past records. When general interest rates rise, the appetite for current debt funds decreases, resulting in lower NAV and lower returns. When interest rates fall, the reverse happens.
Interest you receive from a fixed deposit is added to your net income and taxed at your tax rate. TDS is levied on interest earned if it exceeds Rs. 40,000 for regular residents and Rs. 50,000 for seniors in a year. While there are short-term capital gains (STCG) for holding periods of up to 36 months and long-term capital gains (LTCG) for holding periods greater than three years when it comes to debt mutual funds. If you withdraw debt funds within three years, they will be treated the same as a fixed deposit – the gains will be added to your income and you will be subject to income tax at your bracket rate. Debt funds are taxed at 20% with indexation and at 10% without indexation if held for more than three years.
Since debt funds can be repaid at any time, they are more liquid than term deposits. You can make premature withdrawals, but after incurring a penalty, you may be able to earn a lower interest rate on the amount withdrawn from your fixed deposit. You can redeem the assets of your debt fund at the current net asset value, which may be less or more than the amount you originally deposited. The exit charge is applied to debt fund redemptions during the exit charge period and is deducted from the redemption amount. You can exchange units for free after the exit charge time ends. Before investing, you should consider the structure of the debt fund outflow charge and the penalties imposed by banks on term deposits.
Tenure and flexibility
There isn’t much diversity when it comes to fixed deposits. Fixed deposits are available at the post office or at banks. Banks offer different interest rates which are currently around 5.5% of some large banks. Compared to commercial banks, some small financial banks may offer you higher interest rates of more than 7%, but they also come with risk. Debt mutual funds invest in government bonds, RSUs, money market, corporate debentures, etc. Each class of the fund has its own set of risks and rewards. Fixed deposits are for a specific period, ranging from a week to ten years. Loan funds are available for a variety of time periods, ranging from one day (overnight funds) to over seven years (long term funds). There are also short-term debt funds that invest in bonds with terms of one to three years. It is a good choice for low risk investors who have a similar holding period. For investors with higher tax brackets, this is a more tax-efficient option than term deposits. Therefore, you must make your decision based on your financial goals and the length of your investment.
Loan funds have always provided higher returns than term deposits. Debt funds can be a good bet from a tax standpoint, especially if you plan to hold them for a long time. If capital security and guaranteed returns are your top priorities, a fixed deposit investment is a solution. When you compare Debt Fund to FD, you can get potentially higher returns by investing a portion of your fixed income assets in debt mutual funds. You can also benefit from tax advantages in debt mutual funds, which is the main advantage of debt mutual funds. However, if your tax rate is higher and your investment horizon is longer than three years, debt funds are more tax efficient than bank FDs. But here the point of concern is that due to the volatility of interest rates, debt funds may have negative returns and long term debt funds are more exposed to interest rate risk. Debt funds, on the other hand, invest in fixed income assets, which makes them less risky than equity funds. Depending on your investment goals and risk profile, you can choose the best debt fund. Take a look at the debt fund portfolio. Debt funds with AAA rated bonds in the portfolio are safe to bet.