InvestorQ : How do I as an investor make a choice between FDs and debt mutual funds? What are the relative pros and cons of both these instruments for debt investment?
Neelam Naik made post

How do I as an investor make a choice between FDs and debt mutual funds? What are the relative pros and cons of both these instruments for debt investment?

Priyanka N answered.
3 years ago

Fixed deposits (FD) of banks and other large institutions are still a preferred avenue among Indian investors to store money for the long term. With the proliferation of debt funds in the last few years, the question is what could be a better choice? Should investors prefer an FD or a debt mutual fund? While FD continues to be quite popular, investors need to understand the merits of a debt mutual fund from different perspectives. Let us look at some of these key points that can distinguish or compare between FDs and debt mutual funds as an investment class.

Safety of principal is not very different between FD and Debt funds

Many proponents of the FD theory contend that the safety of principal is higher in case of an FD as it is issued by a bank and hence the principal is virtually guaranteed. That is definitely true but you can mirror a similar safe pattern in debt funds too. For example do not go for debt paper below the grade of AA. If you opt for a mutual fund which only invests in government debt and in AAA debt of large institutions, your risk profile will be almost similar to that of a bank FD. Of course, one needs to be cautious about not going too much down the rating curve.

Dividends on debt funds are taxed more favourably than interest on FDs

That is a big advantage that debt funds proffer. When your FD pays you interest, it is taxed at your peak rate of tax. If you are in the 30% tax bracket, then you end up paying 30% tax on your FD interest. With FD rates hovering around 7-8% on a 1-year deposit in a best case scenario, your post tax returns will be just about 4.9%-5.6%. (We have ignored surcharge to avoid confusion). With rates headed further down, it is doubtful if the post tax return on FDs will even compensate for inflation. Debt funds on the other hand, have outperformed that by a margin due to falling interest rates. Dividends are tax free in the hands of the investor but there is a dividend distribution tax (DDT) of 29.12% that gets deducted when the fund pays out dividends. A more efficient way of investing in debt funds will be to opt for the growth plan rather than the dividend plan.

If you are opting for debt fund then opt for growth plans rather than for dividend plans

Since the dividend plans of debt mutual funds may run the risk of the DDT eroding your post-tax returns, opting for growth plans may be a wiser choice. While equity funds attract 0% tax on long term capital gains, debt funds are subjected to tax on long-term capital gains. LTCG on debt funds is taxed at 20% of gains after considering indexation. Indexation is an interesting concept which improves the post-tax yield substantially. The index number is announced by the IT department each year based on the average rate of inflation. Let us take the example of Rajesh who bought a debt fund – growth plan in FY2012-13 at an NAV of Rs.125. He sold the entire debt fund in FY2016-17 at an NAV of Rs.225 resulting in a capital gain of Rs.100 on his debt funds. Here is where indexation comes in. Let us see how to go about calculating the indexation benefits on debt funds for long term capital gains calculation. The IT department has announced the rate of indexation at 852 for 2012-13 and at 1125 for 2016-17. So, to calculate the capital gains you must first calculate the indexed cost of acquisition. In this case of the indexed cost of acquisition will be Rs.165 {125 X (1125/852)}. Thus your capital gains after indexation will be Rs.60 (225-165) and tax at 20% will be just Rs.12. Thus on your overall long term capital gain of Rs.100, you just pay a capital gains tax rate of 12%. This makes it substantially more tax efficient compared to FDs.

There is also an aspect of double indexation benefit that you must be aware of. For example, if you buy a debt fund on March 29th 2015 and sell the debt fund on April 03rd 2018, then technically you have held the debt fund for a few days more than 3 years. However, the indexation benefit will be for a period of 4 years since your holding has straddled across 4 different financial years and the indexation will be applied accordingly.

Remember, debt funds can be a better bet in a falling interest scenario

The RBI has cut repo rates by 175 basis points since the beginning of January 2015. According to analyst estimates, there may be another 100-125 bps cut in repo rates by March 2018. While FDs may become unattractive due to lower rates, debt funds may actually see capital gains due to falling rates. It is well known that there is an inverse relationship between yields and bond prices. As rates fall and yields come down, the bond prices appreciate. This substantially enhances the overall returns on bond funds. The demonetization has left Indian banks flush with liquidity and yields may be headed still lower. Debt funds may be the answer to make the best of this trend. There is also a downside risk to it. When rates are rising the debt funds will see erosion in value. It is not just about rising rates. For example, last year bond yields went up across the board even through the rates were not hiked. This led to bond value erosion in case of debt funds. That is something you need to factor in and focus more on the yield scenario rather than on the interest rates per se.

Lastly, debt funds offer you diversification plus liquidity

Bank FDs are largely static products. There is not much to choose between the FDs of different PSU banks. There is also very little difference between FDs of private banks and PSU banks. There is little to choose between two FD products. Debt funds, however, are a different ball game. You have a wide gamut ranging from G-Sec funds to MIPs to income funds to Dynamic Funds and Credit Opportunities Funds. This enables the investor to diversify his debt portfolio based on the outlook for interest rates. The bigger advantage in debt funds is the easy liquidity that is available. Of course, FDs also offer a loan against the FD value, but that has a cost attached to it. Debt funds, on the other hand, can be redeemed and the sale proceeds can be received in T+2 days. While FDs have been quite popular in India, it is time to look at debt funds as a serious alternative. Apart from the choice and active management, debt funds are also more liquid and tax efficient. In a falling interest rate scenario, debt funds may be a far better bet!