The Fight of the Century – Debt Funds Vs Fixed Deposits

I am not talking about boxing match between Mayweather & Pacquiao…. but the real financial game “Debt Funds Vs Fixed Deposits”.

Mutual funds in India are not bought by the investors; this product is still called a push product, which means people do not invest until someone forces them to. (credit can go to low awareness) The investment in Mutual Fund has increased many folds in last one decade. Most of the existing investors now are comfortable with this product. However out of these still many individual investors only consider it as an alternative to the equity market. They don’t know that there is a vast range of Debt mutual funds schemes available in the market, which are better than the traditional bank deposits in the long run.

Typically debt mutual funds are not popular as equity funds due to one reason the returns are not guaranteed as it is in the bank fixed deposits. (with adding Guarantee word in promotion you can easily sell plots on Mars to Indian investor) Still there are many who understand the advantage of investing into these schemes. So for those investors who don’t know, lets first understand what exactly debt Mutual Fund is all about and then compare it with the bank deposits.

What are Debt Mutual Funds?

Debt mutual funds are those products which invest in mix of fixed income securities like government bonds, corporate deposits, treasury bills, money market instruments with different maturity and interest rates. The objective of these funds is to generate regular income with capital appreciation over the period.

Types of Debt mutual Funds

 Debt mutual funds are broadly classified as Liquid Funds, Ultra Short term funds, Floating rate funds, Income funds, Gilt funds, Fixed Maturity Plans ( FMP ), Corporate Bond funds, Debt oriented Hybrid Funds, Multiple Yield Funds, Capital Protection oriented Funds, etc.

(Rolling 3 year Total Return chart on a NAV basis, over a period of 5 years)

How does debt fund works?

Debt mutual fund schemes hold many fixed income instruments based upon the objective of the scheme. It’s more like a basket of debt securities with different maturity and interest rate. Typically, a bond fund manager selects the securities which are highly rated. This also improves the credibility of the fund. The regular change in the interest rate impacts the price of the security. When the interest rates are in downtrend, the price of the security appreciates and vice versa. A role of a fund manager is to generate regular income from time to time by leveraging the interest rate movement.

How debt funds are different from Bank Deposits?

	Debt Funds	Bank Deposits
Meaning	These are professionally managed funds which invests into different fixed income securities according to the objective of the scheme. # —————	These are the bank products which offer a fixed rate to their customers with a fixed maturity.
Returns	Debt funds do not offer assured returns. The volatility depends upon the interest rate cycles and returns of debt fund depend upon the volatility.Longer the duration higher the volatility and higher the return. Normally, the returns in short term debt funds are equivalent or higher to the prevailing interest rates. # —————	Return is indicated on the bank deposit document which is guaranteed. (not really… tell me why??)
Time Period	Debt funds are available even for 1 day. There is not predefined maturity of a debt fund other than FMPs. It is based upon the requirement of the investor. One can hold the debt fund for as long as he wishes to. # —————	Bank deposits are available from 15 days to the max of 10 years.
Liquidity	All open ended debt fund are liquid. An investor can redeem the fund any time after paying the required exit load, if any. However, close ended debt fund like FMP’s are not liquid. Only those FMP’s which are listed & traded in the stock market are sellable. # —————	Bank depositsare highly liquid in nature. Investor can break FD with any time after paying little penalty out of the interest earned till date.
Taxation	The taxation depends upon the kind of investment option one chooses, i.e. either growth or dividend.In growth option, if the amount is redeemed before 3 years then short term capital gain is applied where the returns are added back to the annual income of an investor and taxed as per slab. If redeemed after 3 years, Long term capital gain is applied, where returns are taxed 20.6% after indexation. In case of Dividend the investor has to bear DDT (Dividend Distribution Tax)  which is now taxed at effective rate of 28.33%. The dividend paid is net of taxes. #	In the case of bank deposits, the interest income is added to the annual income of an investor and he/she has pay tax according to the applicable tax slab. (some people confuse TDS with taxation – if you in 30% tax bracket & TDS is 10%, you still have to pay remaining 20% tax)

Bank Fixed Deposit Vs Debt Mutual Fund

Let’s understand it with the help of an example:-

Suppose on 1^st Jan 2010 Mr. X has invested Rs. 10,00,000 in Fixed deposit of bank at the rate of 9% for 5 years. And Mr. Z has also invested Rs. 10,00,000 for 5 years in the growth option of long term debt fund. Now as returns are not fixed, let’s assume debt fund will also generate around 9% which is current bank rate.

After 5 years on maturity (1^st Jan 2015) Mr. X will get Rs.15,38,623/- and Mr. Z would also probably get  the same amount.

On the interest amount of Rs. 5,38,623/- Mr. X will have to pay 30% tax which will be Rs. 1,61,568. On the other hand Mr. Z would be happy to pay only Rs 19,679 tax.

*Let’s see how:- On long Term Capital Gain, an investor has to pay 20.6% tax after indexation. The calculated indexed cost of Rs. 10 lakh is Rs. 14,40,225 which is subtracted from Rs. 15,38,623/- so capital gain will be Rs 98398 & tax will be approximately Rs 19,679.

Read – Liquid Mutual Funds Vs Savings Bank Account

So, it is clear from the above comparison that debt funds are more tax efficient than bank deposits. Over the long period the returns may vary, so an investor (in higher tax bracket) who is comfortable with the interest rate risk and looking for a long term fixed investment then he/she should always prefer debt funds over bank deposits. However, please remember, an investor should always analyse his requirement and need before investing.