Over the past many generations, the fixed deposit or FD has been the primary instrument chosen by low-risk investors. However, it is now facing a daunting challenge from debt funds. FDs and debt funds serve a similar purpose, but their major areas of difference include safety, returns, liquidity, and taxation.
Presented below is a detailed discussion on the different aspects of FDs and debt funds and a comparison between the two.
Bank deposits are considered to be the safest bet for people in India with regards to their savings. This is because the chance of a bank default is nearly negligible. As compared to this debt funds do not come with any guarantees. The returns of debt funds are linked to the markets and all investors face the risk of default or other kinds of credit issues in the entities that offer up bonds for investment. However, there are different ways to interpret the safety of investments in debt funds.
SEBI, or the Securities and Exchange Board of India, is the regulator of the Indian stock market. It closely monitors and regulates the fund industry. The regular has promulgated varied regulations that keep a tight leash on the risk profile of different instruments, on the valuation method of varied investments, on the risk concentration that each fund is experiencing, and on the degree of equivalence between the declared goals of a fund and its maturity profile. Such measures have proven to be extremely effective in the past and issues have been far and few in between, like the recent instances of JSPL or Amtek Auto, or the widespread default that occurred during the global financial crisis of 2008.
The risk of interest rate is another typical risk associated with debt funds. Debt funds tend to lose value when interest rates rise and gain value when they drop.
Such risk is also evident in fixed deposits with very long tenure lock-in periods, mainly in terms of cost of opportunity. However, the real value of the FD does not experience any loss if it is held till maturity.
Depending on varied factors like registration of an ECS mandate, the proceeds of open-ended debt funds are usually credited within a time-frame of 2 to 3 business days. Debt funds have additional fees or exit loads that are typically charged for redemptions, generally up to three years. Such exit loads are not applicable on liquid funds with only some exceptions for highly short time periods.
FDs are also generally made available to the customer within 1 to 2 working days. However, redemption of fixed deposits before the maturity date often comes with a penalty.
Another main difference between FDs and debt fund is taxation. Bank FDs offer returns which accrue as interest income and they needed to be added to the overall normal income. A large percentage of the investors fall under the top tax bracket of 30 percent and such taxation can deplete a big chunk of the interest accumulated as returns. TDS is also deducted by banks on interest income gained from FDs.
Debt funds which investors hold for less than 3 years also have taxation similar to bank fixed deposits. However, TDS is usually not charged in case of debt funds. The returns of debt funds which are held for more than 3 years are however categorized as long term capital gains and they get taxed at the rate of 20% with indexation.
Debt funds come with credit risk, i.e., loans to more risky borrowers, and with risk of interest rate, i.e., the prices of bonds fall when there is a rise in the interest rates. Therefore, debt funds are compensated with increased returns as compared to returns of bank FDs that come with minimal risk of default.
Making Debt Funds work to your benefit
Presented below are different ways in which you can make debt funds work for you:
- Use the fund’s track record and verify potential returns after tax. Then compare your investment scope with the average maturity of the portfolio of the debt fund. Investors tend to keep money in short-term debt funds for some months, but it may not be used and thus stays invested. If it remains invested for a minimum of 36 months, then the returns after tax will be better than the returns of FDs with similar interest rate.
- Expense ratios make a huge difference to the returns of debt funds and hence investors need to check it before investing. Currently, short-term income funds yields an annualized average return of 7-8 percent and expense ratios ranging between 0.4 percent and 1.5 percent. You can try moving from high-expense funds to others of similar class that offer better returns with reduced expenses. It is important to note that expense rations keep on changing and do not stay fixed. Hence, investors need to compare it within a category.
- Interest rate changes affect both debt funds and FDs. A rise in repo rates causes an increase in the rates of FDs. However in such markets of interest rate hikes, bond prices tend to fall and this can lead to reduced returns on debt funds for some time. Debt fund returns refer to interest gained from securities and bonds in addition to the capital gains received from bonds sold before their term maturity.
- FD returns are lower when interest rates fall. It is therefore a wise decision to invest in debt funds when there is expectation of fall in interest rates as during such markets the returns accrued by debt funds are higher than FD returns as bond prices tend to rise.
- Compare the performance track record of the debt fund to the fixed deposit rates when allocating investments for a time frame of less than three years. Search for funds that have consistently delivered good returns over different cycles of interest rates.