Debt Funds vs Fixed Deposits: Key Differences

India, as a country, has been observed to favour conservative forms of investments. The amount of gold an Indian household holds is a typical example of this. The World Gold Council estimated in 2019 that Indians hold up to 25,000 tonnes of gold, making them among the top five gold owners in the world.

A fixed deposit, too, is one of the most conservative investment instruments. However, are they still relevant today with inflation playing spoilsport? Or are alternative options like debt funds better? In this article, we attempt to understand how fixed deposits are different from debt funds in terms of the returns they offer and the risk involved.

What is a Debt Fund?

A debt fund is a mutual fund scheme that primarily invests in a basket of distinct debt instruments with the objective to deliver optimal risk-adjusted returns. This basket may include corporate bonds, government bonds, corporate debt securities, money market instruments, etc. The constituent instruments are generally not market-linked and offer fixed income in form of interest payments. This is where the scheme derives its name from. These schemes are usually subject to lower degrees of volatility on account of less correlation with broader market movements. Hence they are perceived to be less risky.

Benefits of Investing in Debt Funds

• Debt funds offer higher stability than most relatively aggressive investment options. This is because debt funds primarily invest in instruments that offer fixed income returns that are usually not market-linked.
  
• Due to the underlying objectives of debt funds, they carry comparatively lower risk. They have also been noted for consistently delivering higher returns in comparison to their conservative counterparts. Hence, debt funds are often an ideal choice for conservative investors who want slightly higher returns than bank FDs.
  
• Similar conservative options often have lock-in periods that restrict the liquidity of the investment option. But debt funds usually do not have a lock-in period, which makes them highly liquid.
  
• Since they have higher liquidity and are comparatively safer, they are ideal as short/medium-term investments and to create emergency funds. Further, there are even ultra-short options with a tenure of fewer than six months.
  
• Debt funds give you the flexibility to invest on a monthly basis. This makes investing in them more accessible and investor friendly. 

Also Read: Why Debt Mutual Funds are better than Fixed Deposits

Who Should Invest in Debt Funds?

The attributes of a debt fund make it an ideal option for relatively risk-averse investors who want to earn a decent return on their investment. A lump sum investment in a debt fund could give you a regular income, while an SIP investment could help you invest bit by bit to create a lump sum over time. 

Since the risk relative to equity is lower, debt funds could also be an ideal investment option for beginners. Of course, research and study about the investment option are necessary here, too. Still, due to lower risk, the negative impact of investing in the wrong fund (according to your investment horizon) will be lower.

What is a Fixed Deposit?

A fixed deposit is an investment scheme that banks and NBFCs (Non-Banking Financial Companies) provide. It works like a savings account — the money you have kept in the bank accrues interest.  But fixed deposits provide better interest because the fund you invest in usually has a predetermined lock-in period. An FD is a low-risk investment option because there are no variables like market linkage affecting the returns. Instances of losing money in an FD are virtually non-existent.

Benefits of investing in fixed deposits

The most obvious advantage of investing in a fixed deposit is the fixed return it provides. This makes investment planning easier and more predictable. However, the advantages of investing in FDs do not end there. Below are some of the other benefits of investing in FDs:

• Your money kept in an FD comes with a lock-in period till maturity. Premature withdrawal will attract a penalty. While this may seem restrictive, leaving the deposit untouched for the entire tenure is beneficial.
  
• FD investments benefit from compounding. The interest that your FD accrues is reinvested so that the compounded amount starts earning interest. For instance, if your FD is worth Rs. 5 lakh and it accrues Rs. 40,000 interest, the compounded amount of Rs. 5.4 lakh will start earning interest thereafter.
  
• There is a common belief that FDs are not flexible due to their lock-in period. But modern-day FDs have come a long way from this. Certain banks provide an overdraft facility, allowing you to withdraw up to 90% of your funds, and you have to pay a penalty only for the funds remitted. You can even take loans with your FD as collateral.
  
• The sweep-in facility that banks provide helps utilise FD funds should you fall short of funds in your savings account. This helps avoid situations of dishonoured cheques.

Who should invest in fixed deposits?

Similar to debt funds, fixed deposits are also an ideal investment option for conservative investors. With fixed deposits, you can be assured that your money is safe except for extraordinary crises like the bank closing down. But the biggest prerequisite is a considerable corpus; a smaller investment amount may fail to utilise the power of compounding fully.

FDs also make an ideal place to park your savings. Not only will your savings be risk-free, but they will also accrue regular income.

Read More: Conservative Hybrid Funds: How They Work & How to Invest?

Debt Funds vs FD: Quick Comparison

Understanding the key differences between debt funds and FDs is necessary to choose what suits you.

Risk

As discussed above, both debt funds and FDs are low-risk investment options due to the lack of market linkage. In FDs, the bank gives you fixed interest for the money you keep with them, while debt funds invest in debt instruments that provide fixed income. When comparing both, debt funds are slightly riskier because of factors like variability in the creditworthiness of issuers of constituent fixed income securities, inability to match the benchmark returns etc.

Returns

The risk and return balance of any investment option is the same — the higher the risk, the higher the return potential. Here, too, since debt funds carry higher risk, they have a higher return potential. However, the returns from debt funds are subject to a low degree of volatility in contrast to FDs that provide fixed returns. 

Taxation

Returns from your FD investments are added to your current income and taxed per your tax bracket. The tax deduction from FDs is live. That means you will be taxed while you are invested. With debt funds, Short Term Capital Gains (less than one year of investment) are added to your income like above. But Long Term Capital Gains are taxed at a flat 20%. Taxation is only applicable once you withdraw from the fund.

Liquidity

FDs have a lock-in period. You can withdraw prematurely, which may reduce your returns due to penalty charges. In contrast, you can withdraw from most debt funds anytime, making them more liquid.

Transparency

Banks pay you interest through FDs because they use your money for purposes that benefit them, but there is no way of knowing how exactly they do that. On the contrary, the portfolio of the debt fund you invest in is transparent. You can see and keep an eye on tthe nature of fund optimisation. 

Bottom Line

Both fixed deposits and debt funds can be beneficial investment options. But the perfect choice may vary based on your goals. You can use the above pointers to determine the best option for you and settle the debt funds vs FD dilemma.

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