Debt Mutual Funds and Bank Fixed Deposits

Understand the crucial difference between debt funds & FDs. Find out which fit your needs the best...

In the minds of most investors, debt funds are a direct alternative and competitor for bank fixed deposits. This is a fair comparison, as the two serve the same purpose in anyone's investment portfolio. However, there are some crucial differences and it's important that investors should understand these. The primary areas of difference are safety and taxation (and thus returns), with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.

As with all mutual funds, there are no guarantees in debt funds. Returns are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in. However, that's a legalistic interpretation of the safety of your investments in mutual funds.

n practice, the fund industry is closely regulated and monitored by the regulator, Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund's declared goals.

In the past, these measures have proved to be highly effective and except for some small problems during the 2008 global financial crisis, debt fund investors have not had any nasty surprises. Practically speaking, you would be entirely justified in expecting not to face any defaults in your debt fund investments.

In theory, banks are safer but in our view, there is no practical difference between the safety level of banks and debt funds as far as defaults of underlying investments go. However, that's not a guarantee.

The other big difference is that of taxation. Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this effectively reduces return by an equal percentage. With debt funds, the returns are classified as capital gains for investments of over 12-months for and are thus taxed at 10 per cent or 20 per cent with indexation. If you take into account indexation benefits, then the difference between FD returns and debt fund returns are quite large. And if you can time the investment to get double indexation benefits for say a 370 day deposit, then its quite a bonanza.

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