Fixed deposits are the best investment option for entirely risk-averse investors. However, some of the fixed deposit alternatives have gained popularity in recent years. Let us explore why. An excellent option for the conservative investor, it seeks a regular income from a fixed deposit. It is convenient and hassle-free; all it needs is you to deposit a lump sum for a fixed tenure, and you would earn an assured interest.

Also, fixed deposits are not exposed to market fluctuations. With the changing investment environment, however, people are ready to take more risk for better returns that are also tax efficient. And for those considering options other than a fixed deposit, there are several funds one can choose from.

Alternatives to Fixed Deposits

Debt Mutual Funds

Debt mutual funds invest in comparatively secured investment options such as corporate bonds, government securities and money market instruments. These are considered relatively safer than other mutual funds as they invest in high-rated fixed income securities. However, these funds are sometimes vulnerable to depreciation and appreciation.

But despite this, debt funds are capable of offering much higher returns than fixed deposits. They are highly liquid and can be an excellent alternative to fixed deposits.

Liquid Funds

Liquid funds are a type of debt funds that invest only in high-rated money market instruments that mature within 91 days. The most significant advantage of liquid funds is that they provide liquidity which fixed deposits fail to do so. Therefore, you can not only use liquid funds as an alternative to fixed deposits but also as a means to accumulate emergency corpus to fall back on at times of crisis. Liquid funds are the most secured mutual funds as they invest in high-quality instruments.

Equity Funds

These are a type of mutual funds and are great at beating inflation. It requires a portfolio manager to invest the investor’s funds for ownership of a business, which is also known as equities, like common stocks of publicly traded companies. Forming an excellent alternative to the long-term fixed deposits, they are known for returns that are predominantly higher than fixed deposits. The risk level involved with equity funds is lower when it comes to long-term investments.

Corporate Fixed Deposits

For investors willing to take a little more risk, one can choose from corporate fixed deposit options which are nothing, but an FD offered by corporates. The interest rates for a corporate FD is much higher than a bank FD with flexible tenure options. The downside to this form of investment is that these are not as secure as bank fixed deposits and investors should choose to invest only well-established companies.

Fixed Maturity Plans

Fixed maturity plans invest in debt instruments and securities with coinciding maturities. For example, if a fixed maturity plan has a maturity time of 1 year, it will invest in bonds, securities, and other similar options having a maturity period of less than a year. The flexibility of early withdrawal is not present, and the fund can be accessed only at the time of maturity. Therefore, it is advisable to be careful while deciding on investing in this option as your money would be locked-in until maturity.

Fixed maturity plans are an excellent alternative to a fixed deposit, but they are not very liquid. But on the bright side, the risks associated with investing in these are very low and assure a comparatively higher return.

Government Bonds

In India, these are possibly the best-known alternative to fixed deposits even though the returns generated by government bonds are only slightly higher than a fixed deposit. The lock-in time for these investment instruments is longer, but they offer the investor the option of diversifying their portfolio.

Frequently Asked Questions 

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: 

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.

Also add the amount of STCG in ‘F’ part of ‘CG tab’ under ‘ short term capital gains taxable at applicable rates’