Should you invest in a Fixed Deposit or a Debt Fund?

06 Mar,  2024
By: Eastern Fin Research Team
#Mutual Funds

In India, traditionally, the concept of investments was to save money and park it in fixed deposits or recurring deposits for earning returns. Fixed deposits have been revered for their secure nature. Recent years have seen investors looking towards other modes of investment to earn higher returns compared to Fixed Deposits offered by banks.

Investment in Equity Mutual Funds poses challenges for the investors who only have an appetite for low to moderate risks. Debt Mutual Funds, however, have emerged as a popular alternative to Fixed Deposits.

Debt Funds or fixed income Debt Mutual funds are more stable than an equity fund and still have the potential to earn higher returns than a fixed deposit for the investors. But, since May 2022, even bank deposits have started offering rates of interest as high as 7.5% in certain cases. Also, since April 2023, the capital gains on Debt Funds purchased after 1st April 2023 have become taxable in the hands of the investor with no adjustments to inflation as was provided earlier. In such a scenario, which should be the better choice for investors?

In this article we will look at the benefits of a Debt Fund vis a vis a Fixed Deposit.

What is Debt Mutual Funds?

Debt Mutual Funds have their underlying holdings as corporate debt securities, Government bonds and money market instruments. Also called fixed income funds or bond funds, debt funds have a pre-decided maturity date and a fixed interest rate accruing to the investors. At the end of the maturity period, the investor receives the principal amount along with accrued interest.

Reasons why a Debt Mutual Fund may be a better investment option than a Fixed deposit -

1. Higher returns: The first and the foremost reason to choose a debt fund over an FD is that Debt Mutual Funds do have the potential to give slightly higher returns than a traditional FD.

2. Safe Investment: The main reason why an FD was chosen over other modes of investment was for its safety. In the case of Debt Funds too, an AAA rated security managed by a good fund manager gives the dual benefits of slightly higher returns coupled with secure investment.

3. Lock in period: Once you have invested in an FD, your money is locked in for the tenure of the deposit which is generally upward of 6 months. In a debt fund on the other hand, there is no lock-in as these are open-ended funds. However, withdrawing before the exit load period may attract exit load, if any. For the same reason, Debt funds are more liquid than an FD.

4. Investment for very short period: Debt funds offer you to invest for few days through overnight funds, few weeks through liquid or ultra short-term funds and for few months through short term funds with an option to withdraw the funds anytime you need. However, this flexibility to invest with short term needs or goals with high liquidity is not available in Fixed Deposits.

5. Returns are based on performance of underlying securities: The rate of interest is fixed at the time of starting the FD. So, you cannot expect any changes in your returns over what you initially signed up for. The returns from Debt Funds are generally higher than FD and depend on the performance of the underlying securities. The returns from these securities depend on the interest rate in the market. The relation between the returns from Debt Funds is inversely proportional to the interest rate in the market. A lowering of interest rate increases the returns of the Debt Funds. In the short to medium-term, interest fluctuations are not very pronounced. Therefore, Debt Funds investing in shorter and medium duration securities are less volatile than those which hold bonds of longer duration.

Taxation on Debt funds

Post April 2023, capital gains from investments into Debt Mutual Funds are taxable at marginal rates as per the slab of the investor. In this regard at least, there is no difference between an FD and a Debt fund, as even the interest earned on FD is taxable in the hands of the investor. However, banks apply TDS on Fixed Deposit maturity amount / interest, beyond a threshold limit.

Fixed Deposit or Debt Fund?

So, what should an investor choose? The decision between whether you should choose a Debt Mutual Fund or a Fixed Deposit depends on your risk appetite, investment horizon and your goals. If you are not completely risk averse, want a higher return than FD and have staggered investment goals – ranging between few days to many years - then debt funds are a great option for your portfolio.

In the end, the decision of whether you should choose a completely safe investment like an FD with lower returns, or an investment option that gives you safety coupled with a possibility of slightly higher returns is your choice.

You may consult with your Eastern Financiers mutual fund distributor to help you decide how and which Debt Mutual Fund can be a good addition to your portfolio.

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