Fixed Deposits (FD) are not just investments, they are a part of Indian tradition and culture. What most people don’t realize is that they can earn more interest with similar levels of risk by investing in debt funds instead of FD.

But now debt funds are becoming an increasingly widespread rival to the hallowed FD.

A debt fund is a type of mutual fund which invests most of the money gathered from investors into fixed income instruments like corporate bonds, government bonds (both state and central), bonds issued by banks, certificate of deposit, treasury bills etc. These mutual funds are best for investors who are risk averse in nature and do not wish to invest in stock market.

Let us see why traditional investors are switching from FDs to Debt Mutual funds.

Why Debt Funds are Better than Fixed Deposits

The declining interest rate regime and the excessive liquidity caused by last year’s demonetization have forced banks to reduce their FD interest rates to historic lows. This, in turn, is forcing many retail investors to turn towards smarter investment alternatives like debt mutual funds.

Investment in debt mutual funds is a much better option than parking your money in bank FDs. Let us look in major reasons for this.

1. Returns on Investment

After demonetization, many banks lower the FD rates due to excessive liquidity. State Bank of India (SBI), for example, currently offers 6.9 % for 1-year deposits, compared to 8% in 2015. For a 3 year deposit, it is even lower at 6.60%.

Debt funds have historically given returns in the range of 7-9% per annum.

As the returns of debt funds demonstrate, you can beat the banks by investing in debt funds. Debt fund investors assume both credit risk and interest rate risk and are hence compensated by higher returns.

2. Taxation

The big difference between this two low-risk investment instruments is that of taxation.

In case of Fixed Deposits (FD)

The interest earned from FDs is added to your annual income for taxation purposes. Hence, the tax rate on interest earned from FDs will depend on your income tax slab, i.e. 5 %, 20 % or 30 % on the interest received.

For example, if your annual income, after including interest earned from your FDs, falls within the 30% tax bracket, the interest component will attract 30% income tax. Since many investors are in the top tax bracket, this takes away a large chunk of their returns.

In case of Debt Funds

Taxes upon debt mutual funds are of two types depending upon the period for which they are held. These two types are:

Short-term Capital Gain Tax: This is applicable to debt mutual funds held for a period of 36 months or less i.e. anything less than 3 years. In short-term capital gain tax, tax on funds is calculated as per income tax slab of the individual, i.e. 5%, 20% or 30% on the amount of gain.

Long-term Capital Gain tax: This is applicable to debt mutual funds held for a period of 36 months or more i.e. anything more than 3 years. In long-term capital gain tax, tax on funds is calculated at the rate of 20 % with cost indexation on the amount of gain.

Read moreTaxation on Mutual Funds in 2018: A Complete Guide

Indexation is the adjustment of your purchase price with respect to the effect of inflation in an economy and helps you to pay low taxes on your capital gain.

For example, 

ParticularsFixed DepositsDebt Funds
Invested Sum₹ 10 lakhs₹ 10 lakhs
Return Rate10 %10 %
Lock-in Period5 year5 year
Fund worth at the end of tenure₹ 15,00,000₹ 15,00,000
Inflation per year8 %8 %
Indexed Investment Sum –₹ 14,00,000
Taxed Amount₹ 5,00,000₹ 1,00,000
Tax to be paid₹ 1,50,000₹ 20,000
Possible returns after tax₹ 3,50,000₹ 4,80,000

Thus, even if a bank FD and a debt fund generate the same rate of return, the debt fund will still generate a higher post-tax return, provided you come under 20% or 30% tax bracket and your investment horizon is more than 3 years.

Tax Deducted at Source (TDS)

Apart from above mention taxation, banks also deduct TDS on interest income from fixed deposits. It was introduced to collect tax at the source from where an individual’s income is generated.

As per the Income Tax Act, any company or person making a payment is required to deduct tax at source if the payment exceeds certain threshold limits. TDS has to be deducted at the rates prescribed by the tax department.

As a resident Indian, there will be no TDS when you sell/redeem your debt fund units. You are required to show the income and pay taxes, if any when you file your returns.

3. Liquidity

Turning to liquidity, open-ended debt funds proceeds are credited within a period of 2-3 working days depending on factors such as whether an Electronic Clearing Services (ECS) mandate is registered. FDs are also typically available at 1-2 day’s notice, but usually, carry a penalty if they are redeemed before the maturity date.

Banks penalize premature withdrawal of FDs by paying lower interest rate than the original booked interest rate. Premature withdrawal is however not allowed in tax saving fixed deposits as they have a lock-in period of 5 years.

Most banks currently deduct 1% from the original booked rate or 1% from the original card rate applicable for the period for which the FD has been in force, whichever is lower. These may adversely impact your FD’s effective rate of return in case of pre-mature withdrawal during emergencies.

Debt mutual funds, other than Fixed Maturity Plans, do not restrict redemption. However, many funds charge exit loads, ranging from 0.25–1% of the redeemed amount, if they are redeemed within a pre-specified period. Such periods can range anywhere from 15 days to 6 months.

Ultra short-term and many short-term funds do not charge exit loads. Such debt funds will suit best to park your emergency fund.

4. Risk Associated

Bank FDs can be rightly considered as one of the safest avenues for parking your surpluses. The reason is that Deposit Insurance and Credit Guarantee Corporation (DICGC), an RBI subsidiary, guarantees all bank deposits of up to ₹ 1 lakh in the event of your bank’s failure.

The coverage extends to all types of bank deposits, including fixed, savings, current and recurring deposits.

Debt funds are relatively less risky than equity funds, but they are not risk-free like the way bank FDs are. Though they invest in government securities, money market instruments, and corporate deposits, the investors are still exposed to the risk of default or bankruptcy of concerned parties. This makes it riskier as compared to traditional Fixed Deposits.

But, the risk associated with debt funds is slow low, it is comparable to that of fixed deposits.

5. Types of Debt Fund

There is a wide variety of debt funds available in the market. You can choose from them, depending on your risk appetite, your need for liquidity and other investment goals. This feature is not available with FDs.

Read More : 10 Types of Debt Funds (and How to Choose the Best for You)

Top Debt Funds That Gave Better Returns Than FDs

Here’s the list of some debt funds to compare returns to FDs in past:

ICICI Prudential MIP 25

This is a Monthly Income Plans (MIPs) type Debt Mutual Fund launched on March 30, 2004. It is a debt fund with moderately low risk and has given a return of 10.29% since its launch. Returns per annum over the years from this fund are:

DurationReturns on Mutual FundAverage of FD Rates
1 year 8.39 % 6.75 %
3 years 8.85 % 7.50 %
5 years 11.76 % 8.90 %

Franklin India Low Duration Fund

This is an Ultra Short Term Fund type Debt Mutual Fund launched on July 26, 2010. It is a fund with very low risk and has given a return of 9.38% since its launch. Returns per annum over the years from this fund are :

DurationReturns on Mutual FundAverage of FD Rates
1 year 8.27 % 6.75 %
3 years 9.18 % 7.50 %
5 years 9.45 % 8.90 %

Franklin India Ultra-Short Bond Fund

This is an Ultra Short Term Fund type Debt Mutual Fund launched on December 18, 2007. It is a fund with very low risk and has given a return of 8.89% since its launch. Returns per annum over the years from this fund are:

DurationReturns on Mutual FundAverage of FD Rates
1 year 8.13 % 6.75 %
3 years 9.09 % 7.50 %
5 years 9.47 % 8.90 %


Debt funds clearly outscore bank FDs in terms of returns, liquidity, investment options, various types and tax treatment.

Bank FDs outscored debt mutual funds only in terms of capital protection and certainty of returns. However, if debt funds are selected wisely, even these risks can be mitigated to a large extent.

Ultimately, you should weigh your decision on your risk appetite, time horizon and investment goals. As market looks positive in last few years and there is several prospects for economic growth in coming years with the announcement of Union Budget 2018, it makes more sense to opt for debt funds than fixed deposits.

For your regular allocation to debt, which will remain for more than 3 years, debt funds make a better choice thanks to their consistent long-term track record, tax efficiency and flexibility to shift.

Don’t invest in debt funds without doing your homework. Performance track record along with scheme-specific attributes, portfolio credit quality, fund manager track record and expense ratios really do matter.

To look at some of the best performing funds from every category of mutual funds, check out Groww 30 best mutual funds to invest in 2018.

Happy Investing !