The flagship response of the Reserve Bank of India to battle the Covid-19 related economic crisis has been reducing the interest rates and disincentivizing saving behaviour in our country. With this step and the availability of a wide range of investing options for retail investors in India, we can make a practical comparison between two interest paying instruments with low or no risk. Fixed deposits and Debt Mutual funds are two front runners in the low or no risk and highly liquid bracket of investments for retail investors in India.
The theme of this small write up will be discussing about the investments and their properties based on a few selected metrics that are important to retail investors according to us.
Before we begin to compare both debt mutual funds and fixed deposits against each other, let us first know a few things about them.
Debt Mutual Fund
Mutual Funds are buckets of investments and a particular aspect defines the type of fund. Debt mutual funds consist of bonds or debentures as investments. The defining aspects for debt mutual funds depend on the underlying bonds’
- Issuer Type
- Time Period (Duration)
- Credit Quality of the Bond
Issuer Type – An issuer of a bond may be a government, municipality, corporation, bank or a Public Sector Undertaking (PSU).
Time Period (Duration) – Like a fixed deposit, every bond also has a maturity date and the time between today and maturity date can be seen as the time period. The longer or shorter the duration the more or less volatility the bond is supposed to experience.
Credit Quality – Not all borrowers have the same credit quality due to which there are higher risk and lower risk bonds as well. Higher risk bonds have a credit risk (risk of getting our principal back) versus lower risk bonds.
Purpose of Investment
For every investment, purpose and time period are very critical aspects that can significantly determine its level of success and suitability in a portfolio. Fixed deposits are conventionally used to get minimum return with no risk and debt mutual are conventionally used to reduce the risk of a well-diversified portfolio and capture some extra yield by taking proportionate risk.
When we try to compare both of these against each other, we are absolutely considering the purpose and the time period aspect and try to compare them on a uniform platform. In this particular write-up, we are trying to substitute the fixed deposit part of investors’ portfolio with appropriate debt mutual funds.
|Metric||Debt Mutual Fund||Fixed Deposit|
|Investment Safety||Safe if right fund is chosen||Very Safe (Nor Risk)|
|Scope of Returns||Variable (Can beat FD rates)||Fixed|
|Tax rate||Capital Gains (low with indexation)||Income tax (High for many investors)|
This is important for all investment purposes but more for emergency fund or a rainy day fund or very short term goals for less than one year. Overnight or good quality liquid debt mutual funds are a great substitute for Fixed deposits considering all other metrics mentioned in the table.
Scope Of Returns
This metric should be considered when the investment horizon is medium to long for a proportionate comparison between these two investments. Banking and PSU Issuer bond funds, government issuer bond funds can be good substitutes for fixed deposits to yield more returns in an investor portfolio considering all other metrics mentioned in the table.
Liquidity not only means how quickly can we convert an investment to cash but also whether we have to pay a penalty for premature withdrawal of our investment. For many fixed deposits, there is a penalty if withdrawn prematurely. Except liquid mutual funds (it is only seven days for these too), no debt mutual fund has an exit load or a penalty whenever redeemed.
This is what we are currently experiencing specifically. All the investors that invested their savings in a five year FD in 2016 at 8% interest rate can only get close to 6% currently which is a regular possibility when it comes to Fixed Deposits. Debt mutual funds average out this phenomenon as their prices go up and down with change in interest rates over the medium to long term.
For any high earning individual, payable tax rupees are very important and fixed deposit interest is taxed at the highest possible income tax slab for an individual investor. This negative impact can be reduced if a debt mutual fund is used as the gains are taxed at capital gains rate which come down further if indexation is used in calculating them (more than three years gain).
Now, how do we determine what kind of a debt mutual fund is a good match for us?
The exercise of noting down our investment purpose, time horizon and measuring their importance against the metrics we have used to compare FD and Debt mutual funds will be helpful. Doing the same exercise with your Investment or Financial Advisor who can pick you the best fund with minimal credit risk (non-negotiable metric for choosing debt mutual funds) can yield the best results.