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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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.