Fixed Deposits vs Debt based Mutual Funds

The question of Debt Mutual Funds verses Fixed Deposits has been going on for a long time. Which one serves better for the conservative investor? In the minds of most investors, debt funds are a direct alternative and competitor for bank fixed deposits. This is a fair comparison, as the two serve the same purpose in anyone's investment portfolio. However, there are some crucial differences and it's important that investors should understand these.


The primary areas of difference are in safety and taxation (and thus returns), with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.

What are Debt Funds
Debt based funds are those mutual funds which invest the corpus in debt based instruments. such as government bonds, securities, corporate fixed deposits and debentures.

No guarantees of returns in Debt based Funds
As with all mutual funds, there are no guarantees in debt funds. Returns are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in. However, that's a legalistic interpretation of the safety of your investments in mutual funds.
In practice, the fund industry is closely regulated and monitored by the regulator, Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund's declared goals.
In the past, these measures have proved to be highly effective and except for some small problems during the 2008 global financial crisis, debt fund investors have not had any nasty surprises. Practically speaking, you would be entirely justified in expecting not to face any defaults in your debt fund investments.

Banks are safer
In theory, banks are safer but in our view, there is no practical difference between the safety level of banks and debt funds as far as defaults of underlying investments go. However, that's not a guarantee.

Taxation
The other big difference is that of taxation. Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this effectively reduces return by an equal percentage. With debt funds, the returns are classified as capital gains for investments of over 12-months for and are thus taxed at 10 per cent or 20 per cent with indexation. If you take into account indexation benefits, then the difference between FD returns and debt fund returns are quite large. And if you can time the investment to get double indexation benefits for say a 370 day deposit, then its quite a bonanza. Dividends received on a debt mutual fund are also tax free in the hands of the investor.

LiquidityMost banks allow premature withdrawal of the amount invested in a Fixed Deposit, before the actual maturity date. The interest would be calculated on the basis of the number of days the amount stayed invested with the bank. For larger amounts, banks have surrender charges or penalties. In such cases, money would not be made available without penalties or until the fixed deposit matures.

For Debt Funds, liquidity is similar to individual stocks or equity mutual funds which allow investors to liquidate their units in the market as and when they require. On redemption, one can expect to receive the amount in a day or two from the fund house. The amount received would be based on the Net Asset Value (NAV) of the fund as on the date of redemption.              

What kind of returns can i expect from Debt based funds
Fixed maturity plans (FMPs), which are close-ended debt funds, gave an average return of 5.5 per cent during the July 2010-June 2011 period. FMPs are touted by fund houses as good alternatives to FDs because they are more tax efficient and carry a lower risk. While we compared the average return of debt funds with that of FDs, there are debt funds which have seen double-digit appreciation in their net asset value on an annualized basis, giving higher pre tax return than bank FDs.

One year returns on FD : 6% to 9.5%
Returns on debt based mutual funds : 7.5% to 14%

Summary
The goal of any investor is to accumulate wealth to fulfill future wants and needs. For a conservative investor, protection of principle is of utmost importance. However, financial prudence lies in having liquidity for contingencies, as well as a means for capital appreciation. If you seek capital appreciation and tax comfort, along with reasonable safety of capital, then debt funds score over fixed deposits. On the other hand, if capital preservation is all that matters to you then fixed deposits would be the right option.

Cheers

Manoj Arora

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