The falling rates of bank fixed deposits (FDs) have led many retail investors to look for alternatives to fixed income generating higher returns.
While debt mutual funds (MFs) have gained significant traction among retail investors over the last few years due to higher returns, the setbacks suffered by many debt MFs in the corporate debt segment have scared investors. An in-depth comparison between debt funds and bank FDs can help investors make a judicious choice based on their risk appetite.
Capital protection
FDs with scheduled banks offer among the highest degrees of capital protection. These are eligible for the deposit insurance programme from DICGC (Deposit Insurance and Credit Guarantee Corporation), an RBI subsidiary.
This insurance scheme safeguards each depositor of scheduled banks for cumulative deposits of up to ₹5 lakh, in the case of bank failure. Both the principal and interest components of FDs, current, recurring and savings account deposits are covered under this programme. Those having FDs with multiple scheduled banks would be eligible for the ₹5-lakh cover separately for deposits in each of the banks,
On the other hand, being invested in market-linked debt securities, debt funds do not guarantee capital protection. The instruments, traded in debt markets, are not immune to capital erosion. Additionally, interest-rate and credit risks of the issuing entities are the two major risks that threaten debt MF investments.
Credit risk refers to the probability of default in principal and/or interest repayments by issuers of debt securities. Investors can reduce this risk by investing in debt funds having maximum exposure to sovereign/quasi-sovereign debt papers and/or to the highest-rated corporate debt papers.
Interest-rate risk refers to the probability of principal erosion caused by an increase in the broader market rates or due to the RBI’s policy rates. This risk is significantly higher in debt funds invested in debt securities having longer maturity profiles. Investors may reduce this risk by investing in debt funds with lower maturity profiles, such as overnight, liquid, ultra-short duration, short-duration and low-duration debt funds.
Returns
Bank FDs offer one of the highest degrees of income certainty, even higher than those offered by most small savings schemes. Banks pay interest rates applicable at the time of booking the FDs till the maturity of those FDs, irrespective of any changes in their card rate in the interim.
In case of debt funds, the returns generated are a sum of the interest income of their underlying securities along with their capital appreciation. The capital appreciation of debt securities depends on multiple factors such as changes in policy rates, changes in the credit ratings of the underlying securities, government borrowing programmes, inflation, market intervention by the RBI, and the like. All these factors dim the income certainty from debt funds.
However, debt funds usually generate higher returns than bank FDs opened with PSU and large private banks due to the risk premium offered by market-linked fixed income instruments.
Investment cost
Banks do not charge any fee for opening FDs. However, as fund houses incur various expenses for operating and managing debt funds, they recover these expenses from debt-fund investors in the form of total expense ratio.
Although these expenses are marginal, investors can further reduce them by investing in direct plans of debt MFs. As MF houses do not incur distribution expenses in the case of direct plans, the expense ratios of direct plans are lower than their regular counterparts.
Liquidity
Banks usually allow depositors to close their FDs before the maturity date. Only tax-saving bank FDs and those expressly not allowing premature withdrawals do not offer this feature.
However, most banks usually charge a premature withdrawal penalty of up to 1% on those opting for premature closure. This penalty is deducted from the effective rate of interest of the FD, which is usually the lower of the original rate at which the FD was booked and the card rate of the period for which the FD was in effect.
Investors of debt funds, except for those in fixed maturity plans, are also free to redeem their debt funds as per their requirements. However, many debt funds levy exit load on redemption before the pre-set period. Debt funds belonging to overnight, liquid and ultra-short duration fund categories do not charge any exit load, making them efficient vehicles for realising short-term financial goals and for parking emergency funds.
Tax treatment
The returns generated from bank FDs are added to the depositors’ annual incomes and taxed as per their income tax slabs. In the case of debt funds, capital gains booked from debt funds after three years of investment are treated as long-term capital gains and are taxed at 20% with indexation benefits. Capital gains booked within three years of investing are treated as short-term capital gains and are taxed as per the investors’ income tax slab. Thus, when it comes to tax treatment, debt funds are more efficient than bank FDs for investors falling in higher income tax slabs with investment horizons exceeding three years.
(The author is director, Paisabazaar.com)