Fixed Deposits vs. Debt Mutual Funds: Which is Better?

A lot has been written about debt mutual funds of late. After the amendment in the Finance Bill 2023, investors are confused about whether to invest in debt mutual funds or go with traditional fixed deposits, given that interest rates are continuously increasing. One of the reasons for the confusion is that there is too much information with little or no facts to support it.

Today, we will discuss the two options and try to figure out a better option - if any.

Changes around debt funds after the current finance bill

Before 1 April 2023, if you had invested in a debt fund and held on to the investment for more than three years, you received an indexation benefit on the gains - you had to pay fewer taxes. Let us understand the concept with an example.

Assume you had invested Rs 1,00,000 in a debt fund and sold it after three years for Rs 1,50,000. During these three years, the inflation rate was 5% per annum. In this case, the indexed cost of acquisition of the investment would be calculated as follows:

Indexed Cost of Acquisition = Purchase Price x (Cost Inflation Index of the Year of Sale / Cost Inflation Index of the Year of Purchase)

Assuming the cost inflation index of the year of purchase was 250 and the cost inflation index of the year of sale was 300, the indexed cost of acquisition would be:

Indexed Cost of Acquisition = Rs 1,00,000 x (300/250) = Rs 1,20,000

The capital gains in this case would be calculated as below:

Capital Gains = Selling Price - Indexed Cost of Acquisition = Rs 1,50,000 - Rs 1,20,000 = Rs 30,000

With indexation, there was a huge benefit for investors investing in debt funds. It is gone post the amendment. The gains on debt funds get added to your income and charged as your income tax slab. Does it mean debt funds are no longer attractive? Let us figure it out.

*The figures used in the above example is just for illustrative purpose

Which of the two is a better option?

There is no clear winner, as every investor is different and has unique financial requirements and goals. Let us look at the two options based on crucial parameters and try to find an answer.

Returns: The interest rate offered by FDs is fixed for the entire fixed deposit period. You know what you will receive at the end of the investment period barring some exceptional scenario arising. On the other hand, the returns on debt funds depend on the performance of the underlying assets and can fluctuate based on changes in interest rates and other economic factors.

The top banks in India are currently offering fixed deposit returns of over 7%. Debt funds can provide an interest rate between 6% and 8%. At present, fixed deposit interest income can be higher, but that was the case 18 months ago when fixed deposits used to give 4 to 5% interest income. The interest can change again in the future.

Risks: The main risk associated with these investment options is credit risk. Credit risk is a risk of loss that an investor faces when an issuer defaults on a bond or fails to make payments on time. It is the likelihood that a borrower will be unable to repay their debt or fulfill their financial obligations, resulting in a financial loss for the lender or investor.

FDs from nationalized banks have the least credit risk. RBI has secured fixed deposits of up to Rs 5 lakh. Bonds issued by public sector undertakings and sovereigns also have little risk. Investors tend to go for higher returns, which increases the risk. Investors must check a fund's objectives to understand the risk level.

Flexibility with investment: When you open a fixed deposit account, the interest rate varies from bank to bank and changes with the investment tenure. With debt funds, the fund manager gets to decide portfolio duration in line with the funds' objective.

One of the crucial aspects of investing is diversification. Debt mutual funds allow you to invest in bonds, treasury bills, and commercial papers. For further diversification, investors can invest in different types of debt funds.

Investment cost: What makes fixed deposits really attractive is their zero investment cost. For debt funds, there is a recurring expense ratio that depends on the debt funds - there could be a variation of a few basis points among funds.

Taxation: Post the amendment in the Finance Bill 2023, gains made on debt funds will be added to your income and taxed as per your tax slab. The same rules apply to fixed deposits. However, the way these instruments are taxed is different - though the same at a high level.

Interest on fixed deposits is subject to tax deduction at source (TDS). Every time your fixed deposit matures, and you renew, there is TDS deducted, and compounding is affected. With debt funds, there is no TDS. You only pay tax when you redeem the units and nothing in between.

The final verdict

Investors must understand that these are fixed-income instruments, and if inflation is high, they may only beat inflation marginally. These are conservative investment options, and though they should be part of your portfolio, the exposure should be limited, especially if you want to create wealth. These are excellent options if you want to protect your capital.

With interest rates touching 7.5%, if you have a short investment horizon and fall into a lower tax slab, a fixed deposit can be a better option. Debt funds are an excellent investment option in a portfolio for diversification - they are not out of the game because the indexation advantage is gone. If you are looking for higher returns and are comfortable taking on some risk, debt funds may be a suitable option.

It is crucial to consider your financial goals, risk tolerance, and investment horizon before making a decision.