Authored by Sahil Arora
Bank fixed deposits are often the first port of call for those starting their investment journey. However, despite the recent setbacks to the debt markets, raising awareness of mutual funds has prompted a large section of retail investors to invest in debt funds for their exposure to fixed-income securities.
Let’s look at debt funds and fixed deposits and understand how to choose between the two: Capital protection
Bank fixed deposits opened with scheduled banks are covered under the deposit insurance program provided by DICGC (Deposit Insurance and Credit Guarantee Corporation), an RBI subsidiary. The insurance scheme covers each depositor of scheduled banks for cumulative deposits of up to Rs 5 lakh in case of bank failure.
It covers both principal and interest components of bank fixed deposits as well as current, savings and recurring deposits. Note, for those opening deposit accounts in multiple scheduled banks, the Rs 5 lakh cover would separately apply to the deposits of each of those banks. This makes fixed deposits opened with scheduled banks one of the safest investment options.
Debt funds, on the other hand, do not guarantee capital safety. As their underlying securities are traded in the debt markets, they are not immune from capital erosion. Credit risk and interest rate risk are the other two major risks of investing in debt mutual fund investors.
Credit rate risk of debt funds refers to the default in principal or interest repayments by issuers of their underlying securities. This risk can be reduced by investing in debt mutual funds with high exposure to sovereign debt or the highest-rated corporate debt instruments. Interest rate risk refers to the erosion of the market value of debt instruments due to an increase in the policy rates of the central bank. This risk is considerably higher in debt funds with longer maturity profiles of underlying debt securities.
Investors can minimize this risk by opting for debt funds with lower maturity profiles like liquid, overnight, ultra-short duration, low duration and short duration debt funds.
The interest rate applicable at the time of opening a bank FDs remains fixed till its maturity, regardless of any changes in card rate in the interim. For example, if one opens a bank FD of 3 years tenure at 5 percent., the rate of interest will remain the same until the 3 years tenure ends. This provides a high degree of income certainty in bank fixed deposits, even higher than those offered by most small savings schemes.
The returns generated by debt funds are a sum of the capital appreciation of their underlying securities and their interest income. The capital appreciation of these debt securities will in turn depend on multiple factors including changes in the policy rates and changes in the credit ratings of the underlying securities.
This reduces income certainty from debt funds. However, as debt funds usually invest the bulk of its corpus in market-linked fixed income instruments, debt funds selected well usually generate higher returns than fixed deposits opened with PSU banks and major private sector banks.
Banks do not charge any fee for opening and maintaining fixed deposits. However, fund houses have to incur various expenses for operating their debt funds like management and advisory fees, legal and audit fees, agent and sales commissions, selling and marketing expenses, etc.
All these expenses are aggregated and expressed in the form of operating expenses, which are borne by the investor themselves.
While these expense ratios are very marginal in the case of debt funds, investors can reduce their expense ratio by choosing direct plans of debt mutual funds. As mutual fund houses do not incur distributors’ commission in case of direct plans, their expense ratios are lower than their regular counterparts.
Barring tax-saving FDs, most of the bank fixed deposits allow premature withdrawal. Most banks usually charge a penalty of up to 1% in case of premature withdrawal. The prepayment withdrawal penalty is subtracted from the effective rate of interest of the fixed deposit, which is usually lower of the original booked card rate and the card rate of the period for which the FD has been in effect.
In the case of debt funds, except for the fixed maturity plans, investors are free to redeem their debt funds any time after investment. However, some debt funds may levy exit load on redemption before pre-set timelines. Debt funds belonging to the ultra-short, liquid, and overnight fund categories do not charge any exit load. This makes these funds a prudent choice for parking funds for short term goals and contingency funds.
FD returns are added to your annual income and taxed as per your income tax slab. In the case of debt funds, capital gains booked from redeeming debt funds after 3 years of investment are termed as long term capital gains and are taxed at 20 percent with indexation benefits.
Returns booked on the redemption of debt funds within 3 years are called short term capital gains and are taxed according to the investor's income tax slab. Thus, debt funds are more tax-efficient than bank fixed deposits for those falling in higher tax slabs with investment horizons exceeding 3 years.
Sahil Arora is Director at Paisabazaar.com. Views are personal