Traditionally speaking, India as a nation has been on the fence about mutual funds for most of its history. From its inception in 1965 up until 1987, Assets under Management in the mutual fund industry grew from Rs. 25 crores to Rs. 4564 crore only.

The economic upheavals of the past have, to some extent, crystallised this conservatism into the nation’s DNA – trends mostly pointing to an inherent affinity towards fixed deposits.

However, debt funds bypass this aversion towards mutual funds, creating a niche for individuals looking to mobilise their corpora without the risk connotation of MFs.

Consequently, there arises the dichotomy – debt funds vs fixed deposits.

The thing to know right at the onset is that there’s no “one size fits all” solution here. So, you may want to take a look at the following points to gather a better idea of these investment devices.

Fixed Deposits vs Debt Funds: An Intro into the World of Conservative Investment

The best way to decide which investment option suits your needs is to draw a comparative analysis between them. Following is an elaboration of the characteristic of FDs and debt funds, based on various factors –

  • Definition 

  • FD

You deposit a sum of money for a predetermined period in an FD account and forget about the whole thing (except for taxation) till the end of the maturity. The amount accrues interest at a fixed rate per the chosen regime for that period.

That’s fixed deposit in a nutshell.

  • Debt Funds

Such an investment device accumulates a pool of corpora from several investors and channels the funds majorly towards debt instruments. These are safer compared to equity MFs since the underlying assets in debt funds primarily involve bonds, government securities, money market instruments, commercial papers, etc.

  • Types Under Each

Financial markets are rarely vanilla. Both debt funds and fixed deposits come in several variants, suitable for different financial objectives and horizons.

  • FD
  1. Non-cumulative – FD accounts of this sort offer periodical interest payouts – either monthly or quarterly based on the scheme. The periodical interest, thus earned, remains fixed throughout the tenure.
  2. Cumulative – Unlike the above kind, cumulative FDs do not disburse interest periodically. Instead, the accrued interest is reinvested further, providing for the power of compounding. Hence, interest earned is usually higher.
  • DF
  1. Liquid funds – These invest in short-term debt instruments, like the 91-day Treasury bill. In fact, the maximum maturity period of such funds is 91 days.
  2. Income funds – Fund managers strive to offer stable returns to investors throughout different market conditions. It thus requires active management of funds.
  3. Gilt funds – Such funds are used to invest primarily in government securities. Per mandate, a gilt fund should commit 80% of its corpus to G-secs. Thus, the risk of default is negligible.
  4. Credit opportunities funds – Risky when compared to the rest, these funds aim at maximising returns by investing in low-rated instruments but superior growth potential.
  5. Fixed maturity funds – Akin to fixed deposits, these funds also require investors to lock-in their capital for a specified period.
  6. Short-term and ultra-short-term funds – Typically, these funds involve a maturity period of up to 3 years.

Other than these, money-market funds, corporate bond funds, dynamic bond funds, banking and PSU funds, etc. also come under this category.

  • Risk Involved

This is perhaps the most important factor to understand when it comes to choosing which investment option to choose.

  • FD

FDs offer assured returns to investors, and there’s no fluctuation in the quoted interest you earn, irrespective of how the market performs. The interest rate you lock-in with when making the initial deposit is what applies throughout. Thus, the risk involved is negligible.

  • DF

Although debt funds invest in fixed-income instruments or fixed-income generating avenues, there’s a degree of risk that investors may need to assume. The average tenure plays a crucial role here.

Long-term funds are susceptible to short-term market volatilities since the aim is to maximise returns in the long run. Conversely, short-term funds provide stable returns despite fluctuations.

  • Returns Expected

Just as the risk element of fixed deposits and debt funds differ, the returns they offer also vary.

  • FD

The returns FDs offer usually vary based on tenure and depends on the prevailing market rates.

Typically, when market rates are low, the FD interest rates also dip and vice versa. Repo rates play a pivotal role in the determination of this market rate, which, as of 31st October 2020, is 4%.

However, once locked-in, your deposit will continue earning similar interest at a fixed rate throughout the tenure, irrespective of whether market rates go north or south.

  • DF

The returns debt funds provide are lower than their equity-based counterparts or stocks. But, financial experts believe they have the potential to deliver higher returns than FDs – although, that’s subject to how the market is performing.

Contrary to popular belief, debt-based MF returns are market-linked. But, the extent to which market fluctuations affect those returns vary.

In general, when the general interest rates move up, demand for existing debt funds wanes, leading to a fall in NAV and yields. It’s just the opposite when interest rates fall.

  • Taxation

The following table explains how fixed deposits and debt funds are taxed.

Fixed deposits Debt funds
  • The interest you earn through an FD is added to your total income and taxed per the slab rate applicable.
  • TDS is applicable on the interest earned, which you can later adjust with your tax liability when filing ITR. It’s deducted if the interest earned in a year is above Rs. 40000 for general citizens and Rs. 50000 for senior citizens.
  • Dividends earned from debt MFs are not taxable.
  • The mutual fund is supposed to deduct a Dividend Distribution Tax of 29.12%, which truncates the final dividend that reaches an investor.
  • If you invest in a tax-saving FD, the deposit amount, which is capped at Rs. 1.5 lakh, is entirely exempt from tax under Section 80C.
  • Long-term capital gains from debt funds attract a tax of 20% with indexation and 10% without that. It’s applicable if you redeem your holdings after 36 months.
  • In case you liquidate your investment before 36 months, the gains are added to your income and taxed according to the applicable slab rate.

You can submit Form 15G/H with the bank if your annual interest income from FD does not exceed Rs. 40,000 or Rs. 50,000 so that TDS is not deducted.

  • Liquidity

Gauging the liquidity of these options is imperative if you are looking to invest long term.

  • FD

Depositors must keep their investment intact for 5 years in case of a tax-saving FD. However, in other cases, you can prematurely withdraw from your FD account, which involves a charge.

  • DF

You can redeem your investments in debt funds at the prevailing NAV, which can either be lower or higher than what you initially invested. Such redemption also involves an exit load.

  • Way to invest

The way to invest in these options must be chosen after duly considering your financial standing.

  • FD

You can invest in an FD by depositing a lump-sum amount with a bank or NBFC. Such a facility is available both online and offline.

  • MF

It’s possible to invest in debt funds through third-party platforms such as Groww or directly via AMCs. You can choose between investment options –

  • SIP
  • Lump-sum

These points of difference offer a glimpse into the world of debt funds and mutual funds, and by assessing the whole gamut of your financial objectives in tandem, you can reach a well-informed decision.