This article provides a comparative analysis of Fixed Deposits and Debt Mutual Funds. Though many readers or ‘gurus’ in the investment world might not think this comparison to be apt. We are not suggesting that each one should shift their corpus from FDs into Debt Funds, nor are we implying that Fixed Deposits and Debt Funds carry the same amount of risk. These two are different products but do share a certain grey area of similarity. We are trying to explore this grey area. Those investors who only look at Fixed Deposits and Recurring Deposits to save income throughout their lifetime must understand the gist of this article.
We will begin by clearing some conceptions that investors have about these products. Let me make it very clear that investing in Fixed Deposits is not a path or your ladder to wealth creation. It can’t be. If we look at the returns, inflation and the taxation of this product, mathematically it will never result in creation of wealth. Let me explain. Today the Fixed Deposit rate is close to 7% p.a. compounded annually. Historically the rates range between 6.75% to 9.2% p.a. Investors must realize that the rates that are fetched on Fixed Deposits are closely linked to the level of inflation prevalent at the time. There will mostly not be a situation where an investor fetches 9% p.a. on a FD when the inflation for the year is close to 4%. That is highly unlikely. High rates on FDs will always be linked with higher inflation, so the post inflation returns to the investor (or the inflation adjusted returns) are always minimal.
Moreover, all the interest that one earns on Fixed Deposits is taxable according to the tax slab of the investor. So, if an investor falls in the 30% tax bracket, then he may have to pay a hefty sum in taxes depleting his gains. Debt Funds, when held for a period greater than 3 years are taxed at 20% after indexation. This means that the purchase price of Debt Funds is adjusted for Inflation after which the capital gains are calculated which are then taxed at 20%.
Debt Funds on the other hand have two sources of revenue. The debt funds earn interest on the instruments held as well as get the benefit of Capital Appreciation due to improvement in credit rating of instruments. We must clarify to the reader that Debt Mutual funds do carry a certain amount of risk. But that should not deter investors towards Fixed Deposits. These risks are primarily in the form Credit Risk as well as interest rate risks.
Before we begin to compare the products in greater detail, I would like to share my personal view on this subject. I feel that the money that one needs sometime in the recent future, for important purchases, should not be invested into Debt Funds or for that matter into Equity Funds too. The Debt and Mutual Funds reveal their true worth to an investor who invests in them for a period greater than at least 3years. So if we are given the choice for a product for a period over 3 years, we would recommend Debt Mutual Funds over Fixed Deposits in most cases.
Understanding fixed deposits? Are they beneficial over the long term?
Fixed Deposit is the most secured form of financial instrument provided by banks and other corporate institutions. Fixed Deposit can be opened with any of the public or private sector banks, post offices, NBFC’s and corporate. The amount invested in fixed deposits gets blocked with the bank and you cannot use that money before maturity and a fixed rate of interest is earned by the investor monthly, quarterly or annually. FD’s can be opened in individual as well as corporate accounts.
- Tenure-The maximum tenure of FD is of 10 years and minimum is as low as 7 days.
- Amount-The minimum amount to be invested varies but is generally between Rs 1,000/- to Rs 10,000/-. There is no upper limit for investment.
A) Cumulative-In this plan, your interest amount gets compounded quarterly and gets re-invested along with the principle amount.
B) Non cumulative-In this plan, principle is invested for a fixed period and interest is paid as out to the investor in regular intervals i.e. monthly, quarterly or annually.
C) Tax saver FD– You can earn tax benefit under section 80C of income tax act 1961.The duration of tax saver FD is 5 years and maximum amount of 1, 50,000/- per financial year can be invested in it.
- Premature withdrawal– Premature withdrawal attracts penalty. For example-If you have invested an amount for a period of 180 days but you withdraw the amount in 90 days, then you will get interest on the slab for 90 days and further a penalty of 0.5%-1% gets deducted.
- Nomination facility– You can nominate a person at the time of opening of fixed deposit account. However you can also add or change the nominee later on.
- Auto renewal-You can auto renew your FD either at the time of opening of FD account or at time of maturity also.
WHAT ARE DEBT FUNDS?
Debt fund is a fund in which the investment comprises of a combination of fixed income investments such as short term and long term bonds, treasury bills, government securities, money market instruments and other debt securities. Debt funds are a safe option compared to equity security as the risk associated with them is very less. Debt funds usually pay an interest to the investor. The amount is collected from the investor public and the collected amount is invested by the professionals in debt securities such as govt. & corporate bonds, commercial papers, cash market instruments etc. The debt funds can be tracked by their NAV’s which depict the returns generated.
Types of debt funds
- Liquid funds
Liquid funds are those funds whose tenure is as low as 91 days. They don’t have any exit load and you can easily redeem your money whenever you wish to. Liquid funds invest in government Treasury bill, certificate of deposit issued by banks and commercial papers issued by companies.
- Ultra short term funds
Ultra short term funds have a maturity period of around one year or a little longer than that. While these funds invest in certificate of deposit and commercial papers, they also invest additionally in bank bonds. The returns expected are higher as compared to liquid funds.
- Short term debt funds
Short term debt funds have a maturity period of around 2-3 years. The investment structure comprises of more of bank bonds and less of commercial paper, certificate of deposit and government securities.
- Long term debt funds
The maturity period in long term funds is of 3 years or more. The best time to invest in long term debt fund is when the interest rates are falling as that will raise the bond prices. Long term funds will be suitable for risk averse investors.
- Gilt funds
Gilt funds are the highest risk bearing funds are they are both short term and long term. Gilt funds require constant watching and quick decision making in order to earn good returns.
Gilt funds invest in government securities. They charge 1% as exit load charges if the same is redeemed before one year.
COMPARISON OF FIXED DEPOSIT AND DEBT FUNDS