5 reasons why debt funds are better than fixed deposits

Still investing in low paying bank deposits? It’s time to choose from debt funds that can provide returns that are much higher than fixed deposits

Kavya Balaji   /   February 17, 2021

Fixed deposits offered by banks in India are paying interest rates of around 3% to 5.5% for a year. This is very low when compared to a few years ago when these bank deposits gave investors more than 9%. Do you know that debt mutual funds can provide you with returns of more than 7%? This is one of the reasons why debt mutual funds score over fixed deposits. There are many other benefits to investing in debt mutual funds. 

Higher earnings

Debt funds gain when there is an increase in the value of bonds in the fund’s portfolio. This happens when interest rates fall. When interest rates rise, the mutual fund will reinvest the proceeds from maturing bonds at higher rates. This is how debt funds are able to provide good returns to investors in any scenario. If you had invested in a well-performing banking and PSU debt fund for five years, you would have earned around 8% while a five-year deposit would have earned just 6.9%.

Better taxation

The post-tax returns on fixed deposits are very low as the interest from this investment will be taxed as per your tax bracket. For instance, if you invest in a deposit that earns 5.5%, your post tax returns will be 3.8% if you are in the highest tax bracket. This is where debt funds can provide investors with higher returns.

The difference in post-tax returns from debt funds will be much higher as the long-term capital gains tax rate is just 20% plus indexation benefits. You can get the indexation benefit on gains from debt funds that have been held for more than 36 months. The cost of acquisition of your investment will be revised as per inflation and this notionally brings down the taxable capital gains. So, your tax liability is reduced. In comparison, interest earned on bank deposits will be taxed at the investor’s income tax slab bracket. 

Liquidity

Unlike bank fixed deposits, there is no penalty for withdrawing your money from open-ended debt funds. You can withdraw money any time you want. For a bank deposit, around 1% of your return will need to be paid as penalty if you exit the deposit prematurely.  Exit loads on short- and medium-duration funds will be applicable only if the withdrawal is made within a year of investing. Most debt funds have no exit loads. Debt funds also allow you to regularly withdraw from the funds if you want regular income.

Variety of schemes

Most advisors suggest that clients try to match the debt fund’s duration to the investor’s financial goals, time horizon and risk profile. Since different funds have different durations ranging from overnight funds to long term debt fund with 10 years duration, you can easily choose ones that are right for your goals. 

Note that debt funds come with risks. However, you have the flexibility to decide what type of risk you want to take. You can choose shorter term funds if you don’t want to take much risks. For instance, banking and PSU debts are considered to have credit profile that is of a bank deposit. So, you can choose from various funds that are right for your goals.

Portfolio diversification

Most debt funds invest in a diversified portfolio. So, portfolio exposure to a single security that may be downgraded is minimised. Default risks are also reduced. For instance, in the case of the DHFL default, the exposure of open-ended funds to the security from this company was typically below 5%. 

Unlike debt funds, bank deposits come with high concentration risks because investors hold large sums of money in one bank and run the risk of losing it all if things go wrong with the bank. There is very little information available to investors in case a bank goes bankrupt. They have very few options for exit or redressal. That’s why open-ended debt funds score higher. Open-ended funds are required to provide regular information to investors on the fund’s portfolio and performance.

So, debt funds are better than fixed deposits. However, you need to select well-managed funds that have performed consistently and make sure that the portfolio is a well-diversified portfolio. If a fund is taking too many concentrated bets or has more credit risk than its peers, you shouldn’t invest in the fund. Reviewing the fund once a year is a good way to stay invested in good funds. 

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