I am 31 years old and I want to actively invest. Should I go for bank fixed deposits ( FDs) or debt funds. What is your recommendation during the current market conditions?
Name withheld
Response shared by Jiral Mehta, Senior Research Analyst, FundsIndia.
Debt Funds hold several advantages over fixed deposits (FDs). When you invest in a debt fund, your money is split and loaned to multiple borrowers. Eg: Central & State Governments, PSUs, Banks and Corporates. This leads to much better diversification. In most debt funds, the money can be withdrawn anytime without any exit penalty.
Unlike FDs, debt fund gains are taxed only when you redeem. This allows better compounding of returns over the long term, and you also have the option to plan your redemptions in such a way that your tax outlay is reduced. The credit risk varies from low to high.
But this risk can be minimized largely by choosing debt funds with high credit quality. There can be some fluctuations in your returns due to yield movements. The return predictability is therefore lower compared to FDs. However, this has also been addressed largely by Target Maturity Funds.
Debt funds provide scope for higher returns if interest rates fall and vice versa. We believe that we are close to peak yield levels of the current interest rate cycle. Any fall in yields could lead to better returns from your debt funds in the near term.
FDs vs Debt Funds
Fixed Deposits (FDs) are widely recognised in India as a fundamental investment option, known for providing a stable and assured method of expanding financial reserves. By engaging in an FD, individuals entrust a specific sum of capital to a financial institution such as ICICI Bank, where it is held at a fixed interest rate for a set duration.
Investor preferences allow for the selection of periodic interest payouts, which can be received on a monthly, quarterly, or cumulative basis (upon maturity). The reliability and secure returns associated with FDs establish them as a favored preference among risk-averse investors. Nonetheless, it is important to note that FDs exhibit limitations, especially concerning tax efficiency and adaptability.
Debt Mutual Funds are managed by Asset Management Companies (AMCs). These funds collect capital from multiple investors with the intention of acquiring various debt securities like corporate bonds, government securities, and treasury bills. In contrast to Fixed Deposits (FDs), Debt Funds deliver returns that are connected to the financial markets, potentially resulting in higher yields. Furthermore, they offer diversification across a range of debt instruments and sectors, a strategy that aids in risk management.
Investment strategy
Return on investment: Fixed Deposits (FDs) are known for their fixed interest rate, which is typically lower than the potential returns from Debt Funds, especially over a longer investment horizon. Debt Funds have the potential to offer higher returns compared to FDs but are also subject to market risks due to fluctuations in the market.
Risk assessment: Fixed Deposits (FDs) are considered to have almost negligible risk since they are nearly immune to market fluctuations. On the other hand, Debt Funds carry some level of market risk but offer more stable returns with a lower risk profile than Equity Funds. Diversification and selecting funds with high-quality credit instruments can help manage the risk associated with Debt Funds.
Liquidity: Fixed Deposits (FDs) often come with a lock-in period and may incur penalties for early withdrawal. In contrast, Debt Funds provide higher liquidity, allowing investors to enter and exit as needed without significant penalties. This flexibility in Debt Funds aligns with investors’ financial needs and goals.
Taxation of FDs and debt funds
Fixed Deposits (FDs) are known to be less tax-efficient compared to other investment options. The interest earned on FDs is taxable based on the individual’s tax slab, which can significantly reduce the overall returns, especially for those in higher tax brackets.
On the other hand, Debt Funds are considered a more tax-efficient choice due to their deferred tax treatment and indexation benefits for long-term investments.
Debt Funds have a distinct advantage over FDs when it comes to taxation. For investments in Debt Funds held for over three years, the returns are taxed as Long Term Capital Gains (LTCG) at a rate of 20% with the benefit of indexation. Indexation helps adjust the cost of investment for inflation, thereby decreasing the taxable gains and ultimately lowering the tax burden for investors. While there are tax-saving FD options that can aid in tax planning, they typically come with a lock-in period of at least 5 years.