Why Debt Mutual Funds are Better than Fixed Deposits

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Budget 2021 update :It has been proposed to exempt the senior citizens from filing income tax returns if pension income and interest income are their only annual income source. Section 194P has been newly inserted to enforce the banks to deduct tax on senior citizens more than 75 years of age who have a pension and interest income from the bank.
Fixed Deposits (FDs) have been a part of every Indian household for decades now. The present times, however, are witnessing a slump in FDs with a marked transition toward debt mutual funds. In this article, let’s explore why debt mutual funds are better than fixed deposits.

1.Shift from Conventional FDs to Mutual Funds

There was a time when every extra cash – bonus and increment – went on to be invested in bank FDs. Our grandparents and parents have all ended up putting their money in FDs at least once in their lifetime. It was the best option to earn interest while ensuring capital protection. What has changed now? Mutual funds have come to the fore in the recent few years. As a result, FDs have lost its sheen as the most popular long-term investment goal. During the demonetisation in 2016, mutual funds were able to cash in on the opportunity that became available due to the reduced deposit return rates. Also, due to the availability of tax saving mutual funds, mutual funds rose to prominence. When debt funds started giving more returns with liquidity, many low-risk investors decided to jump ship.

2.Why Invest in Debt Mutual Funds?

Debt funds are the closest which comes to conventional FDs in terms of risk. A debt fund’s primary goal is to give investors steady income throughout the investment horizon. So, you must choose a time horizon in line with that of the fund. You can find out about various debt funds and their duration directly from the fund houses or online or through a third-party. This will help investors understand a fund’s performance concerning interest rates. It will also make it easier for you to take advantage of the market volatility by making informed decisions.

3.Debt Mutual Funds vs Fixed Deposits

Let’s have a look at the differences between fixed deposits and debt funds. The table below helps you decide which investment is suitable for you.

 

 

Particulars

Debt Funds

Fixed Deposits

Rate of returns

7%-9%

6%-8%

Dividend Option

Yes

No

Risk

Low to Moderate

Low

Liquidity

High

Low

Investment Option

Can choose either a SIP investment or a one-time investment

Can only opt for a lump-sum investment

Early Withdrawal

Allowed with or without exit load depending on the mutual fund type

A penalty is levied upon premature withdrawals

Investment Expenditure

A nominal expense ratio is charged

No management costs

Banks offer a pre-set interest rate for fixed deposits based on the tenure chosen. Debt fund returns, to a great extent, depends on the overall interest rate movement. They might generate moderate returns (relatively more than fixed deposits) in the form of capital appreciation and regular income. One good thing about fixed deposits is that market highs and lows will not impact the returns you earn. So typically, debt funds outdo fixed deposits by a considerable margin during times of low-interest rates in the economy.

4.Taxation on Debt Mutual Funds and Fixed Deposits

Short-term gains (i.e. less than three years) on debt funds are taxable as per your tax slab rate. Long-term gains (i.e. up to three years or more) on debt funds are taxable at 20% with the benefit of indexation. As for fixed deposit returns, the gains will be taxed as per your tax slabs.

5.Inflation Adaptability of Debt Mutual Funds and FDs

Everyone knows that inflation puts a damper on savings as it leads to loss of currency value. Debt mutual funds, albeit the risk, have the potential to pace with inflation. For instance, if you have invested in an FD at 6% interest, and the inflation rate is 5%, the adjusted return would be merely 1%. Debt funds may deliver relatively higher returns. Summing up With an Illustration

 

Particulars

Debt Funds

Fixed Deposits

Invested sum (Year of purchase-2015)

Rs 2,00,000

Rs 2,00,000

Return rate

7%

7%

Holding period

3 years

3 years

Fund worth at the end of tenure

Rs 2,45,000

Rs 2,45,000

Inflation

Adjustment available

Adjustment not available

Indexed Cost of Acquisition (Year of sale-2019)

Rs 2,20,472

Taxed Amount

Rs 24,528

Rs 45,000

Tax to be paid (assuming highest tax bracket of 30%)

Rs 4,906 (Tax rate applicable is 20%)

Rs 13,500

Returns after tax

Rs 40,094

Rs 31,500

Ultimately, you should weigh your decision on your risk appetite, income tax slab, time horizon, and investment goals.

FAQs (Frequently asked Questions)

As a tax-paying citizen, the Section-80c of the Indian Tax Act allows you some breather –
a deduction of up to 150,000 from your total annual income.
  • What are debt funds?
    A debt fund is a mutual fund that puts money in fixed income instruments such as government and corporate bonds, treasury bills, commercial paper, certificates of deposit and so on. SEBI has categorised and rationalised debt funds into 16 categories. It categorises debt funds depending on where they invest the corpus.
  • How to invest in debt funds?
    You may invest in direct plans of debt fund schemes through the asset management company. You could invest in regular plans of debt fund schemes with the help of a mutual fund distributor. You may consider investing in debt funds through an online platform such as cleartax invest.
  • What are short term debt funds?
    Short term debt funds invest in bonds with a maturity period of one to three years. It is suitable for low-risk investors with a similar investment horizon. It is a tax-efficient investment as compared to fixed deposits for investors in the higher tax brackets.
  • Why are debt funds falling?
    Debt funds are facing redemption pressure. The secondary market for bonds and money market instruments is shallow in India. As trading volumes dwindle, selling pressure pushes up the traded yield levels. It leads to a fall in prices and debt funds give negative returns.

    RBI has been cutting the repo rate in recent times. A falling interest rate regime results in a lower return from short-term debt funds. However, long-term debt funds perform well in a falling interest rate regime.
  • How do debt funds work?
    Debt funds generate returns by putting money in bonds and fixed-income securities. Debt funds would purchase these securities and earn an interest income. The yields you and other investors receive from debt funds is based on the interest income.

    Debt funds invest in different types of bonds whose prices rise and fall depending on interest rates in the economy. If a debt mutual fund purchases a bond and its price rises due to a fall in the interest rates, it would make additional money over and above the interest income.
  • When to invest in debt funds?
    You must diversify your portfolio with debt funds to protect it from the volatility of the stock market. You must always include debt funds in your portfolio irrespective of your age and how the interest rates move in the economy.

    You may invest in debt funds based on your investment objectives and risk tolerance. You may start investing in debt funds as early as possible and stay invested for a long-term to earn a maximum return.
  • How to invest in debt funds online?
    You may invest in direct plans of debt funds online by visiting the website of the mutual fund house. You may fill up the application form and complete your eKYC by submitting your PAN and Aadhaar details.

    The AMC would verify your details and you may send money through your online bank account. You may invest in direct mutual funds online in India through the online portals such as cleartax invest.
  • How to choose debt funds?
    • You may choose the best debt funds based on the track record of the mutual fund house. Check the investment style of the fund manager before putting money in debt funds.
    • Invest in a mutual fund house with large assets under management (AUM). It may be able to bear sudden redemption pressure during an economic crisis.
    • Check the credit quality of the portfolio of the debt fund. You may consider investing in debt funds with AAA-rated bonds in the portfolio.
    • You may invest in debt funds based on your investment horizon.
    • You could consider your risk appetite before investing in debt funds. Debt funds especially long-term debt funds are vulnerable to interest rate risk.
  • Why are debt funds giving negative returns?
    Debt funds are giving negative returns due to fluctuations in interest rates. Debt funds of longer maturity are vulnerable to interest rate risk.
  • What are ultra-short debt funds?
    Ultra-short debt funds are open-ended debt mutual fund schemes. It invests in bonds with a Macaulay duration of three to six months
  • How to invest in short term debt funds?
    You may invest in direct plans of short-term debt funds directly with the mutual fund house. You can invest in regular plans of short term debt funds through a mutual fund distributor. You may also invest in short term debt funds through an online platform such as cleartax invest.

    • You must log on to cleartax invest
    • You then select the mutual fund house from the list of fund houses
    • Select the short term debt funds from under the category debt funds, based on your investment objectives and risk tolerance and click on Invest now
    • You must select the amount you plan to invest in the short term debt fund scheme and the mode as either One Time or Monthly SIP.
  • How to calculate tax on debt funds?
    You will have to pay capital gains tax on debt funds depending on your holding period. If you invest in debt funds for a time period under three years and then sell your holdings, your capital gains are called short term capital gains (STCG). The short term capital gains are added to your taxable income and taxed as per your income tax bracket.

    If you invest in debt funds for three or more years and then sell your holdings, your capital gains are called long term capital gains (LTCG). The long term capital gains are taxed at 20% with indexation and applicable cess.
  • What are accrual debt funds?
    Accrual debt funds follow an accrual-based strategy. It is a type of debt fund that puts money in short to medium maturity paper. It focuses on holding securities until maturity.
  • What is modified duration in debt funds?
    Modified duration shows you the price sensitivity of a bond whenever there is a change in interest rates. It follows a simple concept that bond prices and interest rates move in opposite directions.

    Modified duration gives you the price sensitivity of a bond to change in yield to maturity. You may calculate the modified duration by dividing the Macaulay Duration of a bond by a factor of (1+y/m).

    ‘y’ stands for the annual yield to maturity and ‘m’ stands for the number of coupon payments per period.
  • How to calculate long term capital gain on debt mutual funds?
    If you invest in debt funds for three years or more and then sell your holdings, your gains are called long term capital gains. Your long term capital gains in debt funds are taxed at 20% with the indexation benefit.

    Indexation helps you adjust the purchase price of debt funds for inflation. You may use CII or the Cost of Inflation Index to index the acquisition cost of the units of debt mutual funds.

    For example, if you purchased 1,000 units of a debt fund in FY 2013-14 at an NAV of Rs 15. You sold the 1,000 units of the debt fund at an NAV of Rs 22 in FY 2018-19. As you have held the debt fund units for more than three years, your gains of Rs 7,000 (Rs 22- Rs 15) * 1000 are called long term capital gains.

    You have CII for FY 2013-14 as 220. (CII for the year of purchase)
    You have CII for FY 2018-19 as 280. (CII for the year of sale)

    ICoA = Original cost of acquisition of debt funds* (CII of the year of sale/CII of year of purchase) where ICoA is the indexed cost of acquisition.

    ICoA = 15000 * (280/220) = 19,091.

    Hence, instead of Rs 7,000, your capital gains will now be Rs 2,909, i.e. (Rs 22,000 – Rs 19,091).

    You have to pay long term capital gains tax of 20% on Rs 2,909 which works out to Rs 582.
  • Where do debt mutual funds invest?
    Debt mutual funds put money in fixed income instruments such as government and corporate bonds, treasury bills, commercial paper, certificates of deposit and other money market instruments.
  • How to calculate indexation in debt funds?
    Indexation helps you adjust the purchase price of debt funds to account for inflation. You can understand the calculation of indexation in debt funds with this example.

    Suppose you invested Rs one lakh in debt mutual funds in FY 2015-16. You redeemed your investment in FY 2019-20 for Rs 1,50,000 after more than three years. Your capital gains are Rs 50,000.

    You have CII for FY 2015-16 as 254. (CII for the year of purchase)
    You have CII for FY 2019-20 as 289. (CII for the year of sale)

    You have the Inflation Adjusted Purchase Price of debt funds = Actual Purchase Price of debt fund X (CII in the year of sale/CII in the year of purchase)

    = 1,00,000 * (289/254) = 1,13,780.
    Capital gains after indexation = Rs 1,50,000 – Rs 1,13,780 = Rs 36,220.

    You have to pay LTCG tax at 20% on Rs 36,220 instead of Rs 50,000 (Rs 1,50,000 – Rs 1,00,000)

    You pay long term capital gains tax of Rs 7,244 which is 20% of Rs 36,220 on your LTCG on debt funds.
  • What are the different types of debt funds?
    SEBI has categorised debt funds into sixteen categories. You have overnight funds, liquid funds, ultra-short duration funds, low duration funds, money market funds, short-duration funds, medium duration funds, medium to long-duration funds, long-duration fund, dynamic funds, corporate bond funds, credit risk funds, banking and PSU funds, gilt funds, gilt funds with 10-year constant duration and floater funds.
  • Which are the best debt funds?
    You may select the best debt fund based on your investment objectives and risk tolerance. Take a look at the portfolio of the debt fund. You may opt for debt funds with AAA-rated bonds in the portfolio. It is safer as compared to lower-rated bonds.

    Pick a debt fund with a lower expense ratio. Take a look at the track record of the mutual fund house and the fund manager before picking the best debt funds.
  • How safe are debt mutual funds in India?
    Debt funds put money in fixed income securities. It is safer as compared to equity funds which invest in stocks and are subject to the volatility of the stock markets. You may diversify your portfolio with debt funds.

    The safety of debt funds depends on the type of debt funds and the interest rate fluctuations. Long-term debt funds may give negative returns when interest rates are rising. Short-term debt funds offer a lower return when interest rates fall. Credit risk funds invest your money in bonds of a lower rating. You may lose money if the bond-issuer defaults on principal and interest repayments.
  • What is the difference between liquid funds and debt funds?
    Debt funds are a type of mutual fund that puts money in fixed income securities. Liquid funds are a subset of debt funds. It invests in fixed-income instruments with a maturity period of up to 91 days. However, other debt funds may have a longer maturity profile.

    Risk: Liquid funds have the lowest risk as compared to other debt funds. It has minimum credit risk and interest rate risk as compared to other debt funds.

    Liquidity: Liquid funds have high liquidity and you can easily redeem them at the AMC as compared to other debt funds.
  • What is the difference between debt and equity mutual funds?
    The main difference between equity funds and debt funds is where they put your money. Equity funds invest mainly in equity shares and related securities of companies while debt funds put money in fixed income instruments.
  • Equity versus debt funds which one to choose and when?
    You may choose between equity and debt funds depending on your investment objectives and risk tolerance. You may invest in equity funds to achieve your long-term financial goals.

    Equity funds would perform well over the long-run say over five years. Debt funds are suitable for short-term financial goals of one to three years.
  • What are equity funds and debt funds?
    Equity funds put money predominantly in equity shares of companies. Debt funds invest mainly in fixed income securities.
  • Why invest in equity funds and debt funds?
    You may choose equity or debt funds depending on your investment objectives and risk appetite. Equity funds would perform well over the long-term and are suitable for long-term financial goals such as buying a house or retirement planning. Debt funds are a safe investment and suitable for short-term financial goals such as saving for a vacation.
  • Why invest in debt funds?
    You could diversify your portfolio with debt funds to protect it from the volatility of the stock market. You may invest in debt funds to achieve short-term financial goals. Debt funds invest in fixed income securities and are less risky as compared to equity funds.
  • What is credit risk in debt mutual funds?
    Debt mutual funds invest in a portfolio of bonds of different credit ratings depending on the type of debt fund. Credit risk is the possibility of a bond-issuer defaulting on principal and interest payments on the bond.

    However, credit risk funds put money in bonds of a lower rating. It is vulnerable to credit risk as the chance of default is higher for lower-rated paper, when compared to debt funds that invest in AAA-rated bonds.
  • Why are debt funds better than fixed deposits?
    Debt funds are tax-efficient as compared to fixed deposits. The interest from bank fixed deposits are added to your taxable income and taxed as per your income tax bracket.

    The capital gains after holding debt funds for a time period under three years are called short-term capital gains (STCG). The STCG is added to your taxable income and taxed as per your income tax slab.

    However, if you hold debt funds for three years or more, your capital gains are called long-term capital gains (LTCG). You would find LTCG taxed at 20% with the benefit of indexation. It makes it tax-efficient as compared to bank fixed deposits.

    Debt funds are tax-efficient as compared to bank FDs if you fall in the higher income tax bracket and have an investment horizon above three years.
  • What is an accrual strategy in debt funds?
    You aim to earn a regular interest income from debt funds and hold the paper until it matures under the accrual strategy in debt funds. Fund managers follow the accrual strategy in fixed income instruments of short or medium-term maturity. It is mainly a buy and hold strategy where instruments in the portfolio are held until maturity.

    Accrual funds are debt mutual funds which aim to earn interest income mainly from the coupon offered by securities they hold in the portfolio. However, accrual funds may obtain some return from capital gains as a small portion of the total return.
  • Where to type stcg on debt funds in itr2 AY 2018-19?
    Short term capital gain on debt funds to be reported in below mentioned places:

    1. Input the STCG details under ‘ Short term capital gain’ point number 5 ‘ From sale of assets other than at A1 or A2 or A3 or A4 above under the tab ‘ CG’ of the ITR utility.
    2. Also add the amount of STCG in ‘F’ part of ‘CG tab’ under ‘ short term capital gains taxable at applicable rates’