Debt Mutual Funds Vs Fixed Deposits: Which is Better in Terms of Returns and Liquidity?

Investment is an integral part of financial planning. Among conservative investors, two prominent alternatives for the growth of wealth are available - Debt Mutual Funds and Fixed Deposits, or simply FDs. Both investment alternatives are considered much safer compared to equities. However, there is a vast difference in terms of returns, liquidity, tax treatment, and associated risks. In this article, we will compare debt mutual fund vs fixed deposit investment options on various parameters such as returns, risk, tax treatment, liquidity, and more, helping investors make an informed decision.

What are Debt Mutual Funds?

It's the fund in which the investors pool together money to invest mainly in fixed-income-generating securities. These mainly involve government bonds, corporate bonds, treasury bills, commercial papers, and other money market instruments. Debt mutual funds are professionally managed by fund managers who choose the right combination of debt instruments to generate stable returns for investors. Risks like interest rates and credit defaults are always monitored.

Debt mutual funds come in various types, depending on their investment objectives and the kind of securities they invest in. Some common types include gilt funds, liquid funds, short-term bond funds, long-term bond funds, corporate bond funds, dynamic bond funds, fixed maturity plans (FMPs), and credit opportunities funds. Each type of fund caters to different risk appetites, ranging from low-risk liquid funds to higher-risk corporate bond funds.

Analysis of Returns in Debt Mutual Funds

The returns generated by debt mutual funds depend on interest earned from debt securities in the portfolio and capital gains (or losses) due to changes in their market value. The performance of these funds is affected by factors such as interest rate movements, inflation, and the creditworthiness of the underlying bonds.

Debt funds are very liable to interest rates. When interest rates are up, prices of outstanding bonds tend to decline. This may impact the decrease in the Net Asset Value (NAV) of the bond funds. However, if the interest rates fall, prices of outstanding bonds increase, hence bondholders obtain returns

Long-term funds may lead to higher returns but they are more sensitive to interest rate changes. Short-term bond funds tend to be less sensitive to changes in interest rates but yield lower returns. High-yield bond funds, which invest in bonds with lower credit ratings, offer higher returns but expose the investor to a greater risk of default.

What are Fixed Deposits?

A fixed deposit is a kind of investment in which an investor deposits a certain sum of amount with the bank or any other financial institution for a fixed term at a fixed rate of interest. Fixed deposits are a relatively safe investment option in India; they give returns based on predetermined rates. They can be suitable for risk-averse investors who prioritise capital protection over higher returns.

Tenure of fixed deposits can be as low as 7 days or as long as 10 years. Interest rates given by banks also vary on grounds like tenure, amount, and the prevalent interest rates.  

Analysis of Returns in Fixed Deposits

The returns on FDs are pre-determined at the time of investment. The interest rate on FDs is variable and differs depending upon the tenure as well as the bank providing the product. The interest earned is compounded at regular intervals, such as monthly, quarterly, or annually, and the investor receives the final maturity amount that includes the principal and interest.

• Fixed Interest Rates: The most significant advantage of FDs is the fixed interest rate. This rate is locked in at the time of investment, providing certainty regarding returns, regardless of fluctuations in the broader economy.
• Compounding Frequency: The frequency at which the interest is compounded has a significant impact on returns. Monthly compounding tends to yield slightly higher returns compared to annual compounding because of the "interest on interest" effect.

Historical Returns of Debt Funds vs Fixed Deposits

Let’s now compare the historical returns of debt funds and fixed deposits. This can help us understand how the two investment instruments often provide returns.

Debt Mutual Funds Returns:

According to historical data, it is observed that debt mutual funds may perform better than fixed deposits in the long term, particularly in low-interest-rate scenarios. Debt mutual funds, on average, have given approx 7-9% returns per annum. This depends on the economic cycle, the credit quality of the underlying securities, and the investment strategy of the fund.

Debt mutual funds have a higher amount of risk compared to any traditional fixed deposit instruments, as it is market-linked. Such products can incur losses in the short term, especially when there’s an unpredicted rise in interest or a credit downgrade of a bond included in the debt mutual fund.

Fixed Deposits Returns:

Historically, Fixed Deposits have been offering stable returns of around 5-7% p.a., depending on the tenure and the interest rate environment. While the returns may seem lower than those offered by debt mutual funds, the stability and low risk of FDs make them a reliable option for conservative investors.

However, returns from FDs are affected by inflation. If the inflation rate is higher than the interest rate on FD, then the real rate of return could be negative, meaning that the purchasing power of an investor decreases over time. 

Tax Implications for Debt Mutual Funds vs Fixed Deposits

The tax treatment of debt mutual funds and fixed deposits differs based on the holding period and the type of income generated (capital gains or dividends). Let’s understand each of them. 

Debt Mutual Funds:

1. Short-Term Capital Gains (STCG): If debt mutual fund units are sold within 3 years of investment, the returns are classified as short-term capital gains and are taxed at the investor’s applicable income tax rate.
   
   
2. Long-Term Capital Gains (LTCG): If the units are held for more than 3 years, the gains are classified as long-term capital gains. The indexation benefit adjusts the purchase price of the units for inflation, thus reducing the taxable gains.
   
   
3. Dividend Distribution: Dividends from debt mutual funds are tax-free. However, the mutual fund houses are required to pay Dividend Distribution Tax (DDT) before distributing dividends.

For example, if you invest in a debt mutual fund for three years and make a profit, you will pay long-term capital gains tax at 20% after adjusting for inflation. This makes debt mutual funds relatively tax-efficient for long-term investors compared to FDs.

Fixed Deposits:

Interests from fixed deposits are taxed as per the applicable income tax slab rate of the investor. The Bank would levy a TDS or tax deduction at source on interest on FD if the aggregate annual interest income exceeds Rs 40,000 for all Banks for senior citizens, though Rs 50,000 from banks. In case you are in the highest income bracket, your returns from FD can get taxed at 30% and may significantly reduce the return you earn.

The important aspect of FD is that interest earned on FD has to be paid as annual tax, though the interest amount may be taken in maturity. It implies that one has to pay annual taxes based on interest income even when not receiving the interest but when it is reinvested.

Liquidity Between Debt Mutual Funds and Fixed Deposits

Liquidity is a key factor to consider while making any investment as it helps determine how easily you can redeem your investments. Here’s how debt mutual funds and fixed deposits offer liquidity to investors.

Liquidity of Debt Mutual Funds

• Redemption Flexibility: The main benefit of debt mutual funds is liquidity. Investors can redeem units on any business day; the redemption would be done at the prevailing NAV of the fund. It provides an investor with access to capital quickly, although the amount may vary based on the performance of the underlying securities.
• Exit Load: There is also some debt mutual fund, charging an exit load when a unit is sold within a certain time period (in the case of most 1 year). This can be more of a small amount of deduction but it does impact overall gains.
• Market Liquidity: The liquidity of a debt mutual fund also depends upon its market conditions and the debt securities it holds. Funds invested in govt. bonds or high-rated corporate bonds can provide better liquidity.

Liquidity of Fixed Deposits

• Premature Withdrawal: Fixed Deposits have a fixed tenure, and early withdrawal can attract penalties, which can reduce the returns. The penalty is usually a reduction in the interest rate by 0.5% to 1% or lower. This is a significant disadvantage for investors who may need liquidity during the FD term.
  
  
• Tax Deduction on Early Withdrawal: Other than the penalty, tax implications also arise from the withdrawal as the FD interest is taxed at the applicable income tax rate.

Which is Better: Debt Mutual Funds or Fixed Deposits?

Aspects	Fixed Deposits	Debt Mutual Funds
Lock-in Period	Typically has a predetermined lock-in period.	Generally offers daily liquidity with no lock-in.
Limited Withdrawal	Limited or no options for partial withdrawals.	Allows for partial redemptions, enhancing flexibility.
Flexibility	Limited flexibility, especially for early withdrawals.	Offers flexibility through partial redemptions.
Market Conditions	Fixed rate of return, irrespective of market conditions.	Returns may vary based on market conditions and NAV
Risk Management	Low to moderate risks because to changes in the market	Low risk and assured profits
Investment Expenditure	An expense ratio is applied at a nominal rate.	No additional management fees are incurred.

Conclusion

Debt Mutual Funds and Fixed Deposits are two unique investment tools, each with its pros and cons. Debt mutual funds come with higher returns, and better liquidity, but involve market risks and inconsistent returns. In contrast, fixed deposits offer stable returns with lower risks. The right choice depends on your financial goals, risk tolerance, and investment horizon. Based on tax implications, liquidity features, and potential returns, investors can choose the option that aligns with their risk appetite and financial objectives. You may also seek expert advice to explore investment options tailored to your needs.