Debt Mutual Funds – An Excellent Alternative to Fixed Deposits

Based on individual’s investment horizons & characteristics, I would like to broadly classify Investment product suitability into two categories:

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Category 1- Equity Mutual Funds (Safety- Theoretically No but in practicality past returns have proven high potential of this asset class provided money is employed for longer horizons, though the same is no guarantee for future performance)

Category 2- Bank Fixed Deposits and Debt Funds are the two recommended options. In this note, I would like to through light on these two options:

Bank FDs vs Debt Mutual Funds

Bank deposits cater to a segment of the investor class that looks for safety and accepts a relatively lower return. Equity Funds cannot clearly be compared with the bank deposits, as investors can expect higher returns from equity funds on only at the risk of losing part of the capital also. Of Late, with increase in Mf penetration & given the risks-return trade off, Indian investors have lowered their FD portfolios & curve this kitty to enhance Debt MF’s portfolios to certain extent. Key characteristics & attributes of both are highlighted below:

A) Safety of Capital

Between Fixed Deposits and Debt Funds, the safety of capital is almost the same. But first, lets’s look at the credit ratings given to different investment instruments.

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B) Fixed Deposits give you Assured Returns / Debt Funds give you Higher Post-Tax Returns

Most Fixed Deposits are AAA rated so the capital invested is highly safe. Debt Funds are not rated per se but you can judge their safety from the investment portfolio. They are usually rated between sovereign to AA.

When you invest in Fixed Deposits, the interest rate on your deposit gets fixed based on the term of the deposit. You can find out what the maturity amount on your Fixed Deposit will be at the time of opening the deposit.

While Debt Funds also offer 7-8% returns, these returns are not guaranteed. Why? This is because there could be a fluctuation in the interest rates.

Tip: Choose a Debt Fund with low volatility.

  • Taxes eat away your income from Fixed Deposits

With a Fixed Deposit, you earn interest. Debt Funds provide capital appreciation and/or dividends.

The interest on Fixed Deposits is taxable as per the tax bracket you fall into. Debt funds are taxable as well, at your personal income tax rate for capital gains realised within 3 years (short term). However, for capital gains realised after 3 years (long term), you are taxed at 20 per cent after indexation. As indexation is taken into account, Debt Funds end up being more tax efficient than Fixed Deposits.

C) Debt Funds Provide Better Liquidity
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D) Fixed Deposits = More Tax Paperwork

Since you need to pay taxes on the interest earned from Fixed Deposits, you need to maintain the related paperwork and calculate your interest income periodically.

With Debt Funds, you only need to pay capital gains tax on any withdrawals. Isn’t that simpler?

Don’t Debt Funds sound like a piece of cake?

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