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Friday, June 07, 2013

Fixed Deposits vs Debt based Mutual Funds

[Last Update : 11-Aug-2017]
In a landmark move that is going to set the tone for future, State Bank of India lowered the interest rate on savings account from 4% to 3.5%. All other banks are likely to follow suit. Fixed Deposit Rates are hovering around 6-6.5%. There has been a reduction of 25% in interest rates of Fixed Deposits of what investors were earning just a couple of years back. The ease and confidence in Fixed Deposits is being challenged by another aspect : worthiness of staying with them.

Background
The question of Debt Mutual Funds verses Fixed Deposits has been going on for a long time. Which one serves better for the conservative investor? In the minds of most investors, debt funds are a direct alternative and competitor for bank fixed deposits. This is a fair comparison, as the two serve the same purpose in anyone's investment portfolio. However, there are some crucial differences and it's important that investors should understand these.
The primary areas of difference are in safety and taxation (and thus returns), with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.

What are Debt Funds
Debt based funds are those mutual funds which invest the corpus in debt based instruments. such as government bonds, securities, corporate fixed deposits and debentures. 

At a very broad level (based on their liquidity), Debt funds can be classified as:
a) Liquid Funds (Highest Liquidity - withdraw the very next day, Least returns - in the range of 6.5 to 7.0%)
b) Ultra Short Term Funds
c) Short Term Funds (Least liquidity, Max Returns - in the range of 8.5 to 9.0%)

Guarantee of Returns 
As with all mutual funds, there are no guarantees in debt funds. Returns are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in. However, that's a legalistic interpretation of the safety of your investments in mutual funds.
In practice, the fund industry is closely regulated and monitored by the regulator, Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund's declared goals.
In the past, these measures have proved to be highly effective and except for some small problems during the 2008 global financial crisis, debt fund investors have not had any nasty surprises. Practically speaking, you would be entirely justified in expecting not to face any defaults in your debt fund investments.

Safety of Principal

In theory, banks are safer but in our view, there is no practical difference between the safety level of banks and debt funds as far as defaults of underlying investments go. However, that's not a guarantee.

Liquidity

Most banks allow premature withdrawal of the amount invested in a Fixed Deposit, before the actual maturity date. The interest would be calculated on the basis of the number of days the amount stayed invested with the bank. For larger amounts, banks have surrender charges or penalties. In such cases, money would not be made available without penalties or until the fixed deposit matures.
For Debt Funds, liquidity is similar to individual stocks or equity mutual funds which allow investors to liquidate their units in the market as and when they require. On redemption, one can expect to receive the amount in a day or two from the fund house. The amount received would be based on the Net Asset Value (NAV) of the fund as on the date of redemption.              

What kind of returns can you expect from Debt based funds

Fixed maturity plans (FMPs), which are close-ended debt funds, gave an average return of 5.5 per cent during the July 2010-June 2011 period. FMPs are touted by fund houses as good alternatives to FDs because they are more tax efficient and carry a lower risk. While we compared the average return of debt funds with that of FDs, there are debt funds which have seen double-digit appreciation in their net asset value on an annualized basis, giving higher pre tax return than bank FDs.
One year returns on FD : 6% to 7%
Returns on debt based mutual funds : 6% to 9%


What about Mutual Fund Running Expenses?
(This section has been added based on a query from one of our readers, Mr. Dharmesh Panchal) 
Mutual Funds do charge a recurring expense ratio which Fixed Deposits do not. Though this may initially seem to be a clear negative for Mutual Funds, but we ought to remember that the NAV of Mutual Funds (and hence the returns they have achieved over time) are calculated only after accounting for this expense ratio. Hence the returns mentioned above are applicable after deducting all Fund management expenses. 
{Recommended Blog post : Understanding Charges on Mutual Funds}

Ease of Investment / Withdrawal
With today's technology being available at your finger tips, one can invest and redeem in liquid funds using mobile apps. Money gets transferred to your bank account within 15 minutes - thus making it almost as easy as booking an online FD. Earning almost 30-40% more interest than an FD with just 15 minutes delay in liquidity is quite worth it. Yes, if you go for ultra short term or short term funds instead of liquid funds, you may have to wait for 2 business days to get the money in your bank account - which, in most cases, can be easily planned.

Taxation
The big difference - other than ROI - is that of taxation. The difference between FDs and Debt based funds get even bigger if you look at post tax returns - which actually is the right way to look at the investment ROI. 
a) Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this effectively reduces return by an equal percentage. 
b) With debt funds, the returns are classified as capital gains - short term capital gains for less than 3 years and for investments of over 3 years - they are categorised as long term capital gains for and are thus taxed only after indexation. Roughly, this means that you are taxed only on inflation adjusted returns. If you take into account indexation benefits, then the difference between FD returns and debt fund returns are quite large. 
c) If you can time the investment to get double indexation benefits for say a 710 day deposit, then its quite a bonanza. 
d) Dividends received on a debt mutual fund are also tax free in the hands of the investor. 
e) FDs are also liable to Tax Deduction at Source @ 10% (or even 20% if your bank does not have your PAN Number in their records). Thus, a part of your interest does not take part in compounding once it is taxed - which again makes a difference in the long run.

Summary
The goal of any investor is to accumulate wealth to fulfill future wants and needs. For a conservative investor, protection of principle is of utmost importance. However, financial prudence lies in having liquidity for contingencies, as well as a means for capital appreciation. If you seek capital appreciation and tax comfort, along with reasonable safety as well as liquidity of capital, then debt funds scores over fixed deposits. In fact, if you are willing to forego all chances of redemption for 3 years - you can earn almost twice the money from debt funds vis-a-vis Fixed Deposits. On the other hand, if capital preservation is all that matters to you then fixed deposits would be the right option.


Article History
2nd Edition : Aug 2017
1st Edition : July 2013

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Manoj Arora
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