Debt Funds vs FD: Know Which is the Best Investment Option

For risk-averse investors who want fixed returns, there are two options: bank fixed deposits and debt funds. While both offer fixed returns and are relatively risk-free, especially when compared to equity investments, there are significant differences between the two. Let’s look at the differences between debt funds and fixed deposits so that you can figure out for yourself which one’s best for you:

Debt Funds vs FD: Differences between Debt Funds and Fixed Deposits

• • Variety: When it comes to fixed deposits there’s not all that much of variety. You can invest in fixed deposits at the post office or at your bank. There are differences in the interest rates banks offer – while a small cooperative bank may offer higher rates, a large bank won’t pay out so much. Of course, deposits at smaller banks involve much more risk. Debt funds offer much more variety – there are funds that invest in government bonds, PSUs, money market, corporate debentures, a mix of equity and debt and so on. The risk and returns are different for each type of fund.

• • Tenure: Fixed deposits are for a fixed period of time, and could range from a week to five years. Debt funds are open-ended and have no fixed tenure. You can hold them as long as you like — a day, a week, or ten years.

• • Liquidity: Debt funds are more liquid than fixed deposits since they can be redeemed at any point. Fixed deposits are less liquid. You can make premature withdrawals, but you may get a lower interest rate on the withdrawn amount.

• • Interest rate risk: An important difference between the two is interest rate risk. In a fixed deposit, the interest rate is fixed for the tenure of the deposit, regardless of changes in overall rates. In a debt fund, returns could change depending on the movement of interest rates. If interest rates go up, yields of instruments in your portfolio will go down, leading to a fall in net asset values (NAVs) and hence your returns. On the other hand, NAVs will go up if interest rates fall.

• • Other risks: In a fixed deposit, since the investment is made in one entity – the bank – you are well aware of the risk involved. Smaller banks involve more risk, large banks less so. Since a debt fund invests in a variety of instruments, it could be hard to gauge the risk. When the infrastructure development and finance company IL&FS defaulted on its obligations, debt funds that had exposure to IL&FS debt had to take a hit, leading to losses for investors.

• • Taxation: Fixed deposits and debt funds are taxed differently. Interest income from fixed deposits are added to your taxable income and you have to pay income tax according to that income. In the case of debt funds, you have to pay capital gains tax. If you redeem debt funds before three years of investment, it will get the same treatment as a fixed deposit – that is, gains will be added to your income, and you will have to pay income tax according to your slab rate. If held for over three years, the tax on debt funds is 20 per cent with indexation, and 10 per cent without indexation. Indexation adjusts the purchase value of your investment for inflation, reducing the capital gain, and hence your tax burden.

Generally, debt funds have offered better returns than fixed deposits in the past. From the tax point of view, debt funds could be a better choice, especially if you hold them over the long term. 

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