Capital Safety, the rate of returns, the lock-in period and taxation are some of the key features that can help you select between debt mutual funds and fixed deposits.
When it comes to investing, for many of us safety comes first and returns come second. After all, no one wants to play gamble with his or her much hard-earned money. Hence, fixed deposits and gold became our favourite investment options. In this craze of safe investment options, we forget that fixed deposits may not be the most ideal investment option.
However, for investors whose priority is capital safety along with inflation-beating returns can look at debt mutual funds. Debt mutual funds are a category of mutual funds that invests in fixed-income securities issued by various companies and governments.
Now, let us understand the difference between debt mutual funds and fixed deposits that can help you to compare the two investment options and choose your pick accordingly.
Interest rate/Rate of returns
Return from Fixed deposits are fixed and are in the range of 7% to 7.5% currently. While interest rates remain the same during the fixed tenure but it may change through the years. Hence, when you want to reinvest the fixed deposit’s maturity amount, interest rates might be different at that time. With the interest rates moving south, banks may trim the interest rates on deposits going forward.
On the other hand, the returns on debt mutual funds are not assured and are linked to the debt market. Debt mutual funds have the potential to deliver higher returns than fixed deposits as fund managers make investment decisions based on the current debt market scenarios and select papers based on credit ratings and internal research. The expected returns from debt mutual funds are normally the Yield to Maturity minus expense ratio if one remains invested till the duration of the fund keeping all other parameters the same. Also, debt funds stand to gain from the lowering of interest rates as the price of a mutual fund unit i.e. net asset value rises when the interest rate falls.
Debt mutual funds have the potential to generate higher real returns. Real returns are the returns given by an investment option above the inflation rate. E.g. if the average rate of inflation in that year was 5% and the interest rate on fixed deposits was 7%, the real rate of return is 2%. A higher real return helps in fulfilling financial goals.
When it comes to capital protection, bank fixed deposits have an edge over debt mutual funds. However, fund houses cannot guarantee capital safety. In the case of FDs, capital protection differs from the issuer of fixed deposits. Non-banking financial companies give higher returns on fixed deposits but it also comes with higher risk than a bank deposit. Though capital erosion risk is very less in debt funds as the portfolio consists of well-researched securities and also due to diversification.
Fixed deposits have a maturity period and you have to pay penalties if you want to redeem your fixed deposits before the maturity date. However, you can redeem from your debt funds anytime you want. However, a few debt funds may have exit loads if you redeem them within the specific time frame. Hence, debt funds are more liquid than fixed deposits.
Taxation: The taxation structure of debt funds is better than fixed deposits as it comes with indexation benefits. There are two types of taxation on debt mutual funds i.e. short-term capital gains and long-term capital gains. Short-term capital gains are applicable if the units are redeemed before three years and gains are taxed as per the income slab. If you stay invested for more than three years, you are eligible for long-term capital taxation at 20% with indexation. Indexation is nothing but accounting for the rise in inflation. In this case, you only pay tax on gains if the rate of returns is higher than the inflation rate. However, in the case of FD, the entire gains are taxed according to the tax bracket of the investor.
Conclusion: Debt mutual funds are a good investment option if you are looking for a relatively stable investment option along with inflation-beating returns. Investors who are in the higher tax brackets can also look at debt mutual funds for tax-efficient returns.