Why Are Debt Mutual Funds A Better Alternative To FDs?

A Debt Fund is a mutual fund which invests in fixed income securities. Fixed income securities include government bonds, certificate of deposit, commercial papers, treasury bills and corporate bonds. Investors with a low-risk appetite consider investing in debt mutual funds and fixed deposits (FDs). In one of our articles earlier, we had discussed the different types of debt mutual funds. This article will tell you why investing in debt mutual funds should be considered over FD.

Safety of capital is same

The safety of any instrument depends on the credit rating of the instrument. Fixed deposits with a AAA rating implies that it carries the highest level of safety. Debt mutual funds are not rated by themselves but their safety can be identified from the portfolio they invest in. While sovereign rating indicates the highest level of safety as it is issued by the Government of India, AAA and AA rating also indicate a high level of safety as the funds are issued by banks, public sector companies and private companies. Moreover, Securities Exchange Board of India (SEBI) being the regulator, keeps a close watch on the fund industry.

Debt funds provide higher returns

Fixed deposits provide fixed returns. At present, the interest rate provided by FDs is 6.5%. If one looks at the historical performance of debt mutual funds, it has given returns of 8-9%. Interest rate fluctuations can cause volatility in debt fund, otherwise they are very safe investments.

Taxation

The returns from fixed deposits are considered as interest income and hence are added to an individual’s normal income. An individual whose income comes in the tax bracket of 30%, tax takes away a large chunk of his returns. The tax rate is same for debt funds held for less than 36 months. However, if debt funds are held for more than 36 months, long term capital gain is applied and the returns are taxed at 20% with indexation.

Debt funds provide better liquidity

The proceeds of open-ended debt funds are credited to an individual’s bank account in 2-3 days. Although fixed deposits can also be liquidated in 2-3 days, there is a penalty for withdrawing FDs before the maturity date. Some debt funds may charge you exit load which is usually 0.25% if you withdraw within a certain period of time.

For example:

Mr. Shah has invested Rs. 1 lakh each in a Bank FD and Debt Fund for a period of 3 years and 1 day. The expected return for both these investments is 7.5%. Which investment will give him a better post-tax return?

	Investment in FD	Investment in Debt Fund
Amount with interest/return	Rs. 1,24,230	Rs. 1,24,230
Index Cost	NA	Rs. 1,15,763
Tax Applicable Rate	30% (Higher Tax Slab)	20%
Taxable Gain	Rs. 24,230	Rs. 8,467
Tax Payable	Rs. 7,269	Rs. 1,693
Net Return (p.a.)	5.40%	7.00%