November 18, 2019
Fixed income products have always been a part of every household savings to give security and growth to investment, at least in the lines of inflation. Traditionally, Fixed Deposits(FDs) and Recurring Deposits(RDs) have been the preferred avenues for regular savings. However, debt mutual funds in recent years have gained popularity due to better returns, higher liquidity, tax efficiency and convenience.
Key Points
Debt mutual funds score over FDs and RDs on several key parameters:
1) Easy Withdrawal
Debt mutual funds are highly liquid and can be withdrawn/redeemed on any working day. Both full and partial withdrawals are allowed, and redeemed money is credited to investor’s bank account on next working day. In many short term debt fund categories, there is no entry or exit charges. Some debt funds levy exit load hence selection of fund category should be done with proper understanding.
2) Better Returns
Debt Mutual funds invest in various fixed income securities like treasury bills, money market instruments, Certificate of Deposits, Government Bonds etc. and are able to generate superior returns than FDs and RDs due to active fund management.
Performance of couple of short term debt funds in past 3 years:
| Performance %* | |||||
| Fund Name | 1 Year | 2 Year | 3 Year | 5 Year | |
|---|---|---|---|---|---|
| Franklin India Ultra Short-Term Fund | 9.86 | 8.86 | 8.74 | 9.16 | |
| HDFC Short Term Debt Fund | 10.32 | 8.03 | 7.78 | 8.28 | |
*Returns shown are compounded annualised, as on 15 November 2019.
*Mutual Fund investments are subject to market risk, past performance is no guarantee for future.
Some debt fund categories like Gilt Funds, Dynamic Bond Funds and Constant Maturity Funds may be volatile in short periods, hence selection of the right fund for individual needs is critical.
3) More Tax Efficient
Tax rate on short term gains on debt funds is similar to other fixed income products if holding period of investment is less than 36 months. But for holding period of more than 36 months, debt funds qualify for indexation benefit and the gains are taxed @20% after adjusting with inflation.
Also, unlike Fixed deposits where TDS is deducted every year on investments, tax in debt funds is charged only in the year of withdrawal, and that too on the gains made on the amount withdrawn.
Here is an illustration to understand the effect of taxation on final returns in case of a debt fund and a fixed deposit.
| Particulars | Debt Funds | Fixed Deposits |
|---|---|---|
| Invested Sum(Rs.) | 1,00,000 | 1,00,000 |
| Rate of Return | 8% | 8% |
| Holding Period | 3 Years | 3 Years |
| Tax liablilty at Highest Tax bracket @30% | 0 | 8,213/- |
| Fund Value after 3 years(Rs.) | 1,25,971 | 1,17,758 |
| Average Inflation for 3 years | 4% | 4% |
| Gains after adjustment for Inflation | 13,485/- | NA |
| Long term Capital gain Tax @20% | 2,697/- | NA |
| Total Tax Paid | 2,697/- | 8,213/- |
| Final Fund Value | 1,23,274/- | 1,17,758/- |
4) Convenience
Once an investment has been made in a debt fund, additional amount can be added in the same fund anytime, unlike FDs where every new investment results in new FD. Also, in case of partial withdrawal, rate of return on the investment does not reduce, unlike an FD where early withdrawal results in reduced rate of return on the withdrawn FD.
Investors who invest in multiple FDs or may have to withdraw early in case of emergencies, find investments in debt funds convenient and easy to manage.
Summary
A summary of comparative study of Debt Funds and Fixed Deposits is given below.
Debt Fund Vs. Fixed Deposit : A Summary
| Particulars | Debt Funds | Fixed Deposits |
|---|---|---|
| High Liquidity | ||
| Assured Returns | ||
| Indexation benefit | ||
| Deferred Tax | ||
| Tax deduction at Source (TDS) | ||
| Partial Withdrawal | ||
| Investment Top Up |
Conclusion:
Debt mutual funds are an alternative for investors seeking safe and regular returns, marginally higher than the fixed deposits. They offer better post tax returns to investors, specially to those who are in the higher tax bracket.
While fixed deposits provide peace of mind because of their assured returns, debt funds provide convenience, stability and liquidity to the investors. As there are variety of debt mutual funds to cater different needs of investor, choosing the right scheme as per the investment objective is crucial for positive investing experience.
As always, your views and feedback on the above are welcome.
Happy Investing!
Tulika Agarwal
Co-Founder, Investguru