Debt funds Vs. fixed deposits: Which one should you choose?

Fixed deposits or FDs are a time-tested savings tool, owing to the ease of application, assured returns, and relative safety. In recent years, however, interest in mutual funds has grown, given their diverse investment avenues and potential to build wealth over time.
Despite the growing popularity of mutual funds, risk-averse investors are apprehensions about them because returns depend on market fluctuations. This is where debt funds come in. Compared to equity funds (which invest in company shares and stocks), debt funds are less volatile because your money goes into fixed-income securities such as bonds, debentures, and treasury bills.
This article will help you understand the differences between debt funds and fixed deposits and the pros and cons of each to help you make an informed investment decision.

• Table of contents:

1. What are fixed deposits?
2. What are debt funds?
3. Debt fund vs FD: Pros and cons

What are fixed deposits?

Fixed deposits allow you to park a lumpsum with a bank or a non-banking financial institution for a specified period. The investment earns interest at a pre-determined rate that remains unchanged throughout the tenure, irrespective of market trends.
Upon maturity, the investor gets back the principal along with the interest. If investor has opted for periodic payment of interest, then interest will be paid on stated time periods with the principal amount paid to investor on maturity.

What are debt funds?

Existing mutual fund schemes have a proven track record, a visible past performance, and an existing portfolio that investors can carefully examine before investing. On the other hand, NFOs are new offerings with no track record. This can sometimes make it difficult for investors to judge whether or not an NFO is worth purchasing.

A debt fund is a type of mutual fund, where money collected from a pool of people is invested in securities, or other assets.
In a debt fund, the bulk of your money is invested in fixed-income instruments such as government or corporate bonds, securities, and treasury bills. This makes it less volatile as compared to stock market-based equity funds. However, debt funds are not completely risk-free because they are influenced by market trends.

Debt fund vs FD: Pros and cons

Let’s look at the advantages and disadvantages of each:

Safety: Fixed deposits are considered among the safest short-to-mid-term savings instruments because the interest rates are fixed, and the returns are near-certain. In comparison, debt funds carry a risk based on the type of security invested by the fund.

Earnings potential: The interest rate for a fixed deposit is determined by the bank and influenced by the Reserve Bank of India’s lending policies. The rate stays the same throughout your tenure. On the other hand, debt fund returns are influenced by market fluctuations and can vary over the investment tenure. Despite this, debt funds are considered relatively stable as compared with equity securities because fixed-income securities are less volatile than stocks. Debt funds have the potential to generate relatively better returns than FDs when the market conditions are favourable at a higher risk than FDs.

Liquidity: Debt funds are usually more liquid than fixed deposits because many of them allow you to redeem your investments at all points in time, subject to exit load. In comparison, most banks levy a penalty if you break your fixed deposit before the maturity date.

Portfolio diversification: Compared to fixed deposits, debt funds offer greater diversification opportunities. Instead of putting all your eggs in one basket, you can opt for a varied portfolio based on your investment goals as well as risk appetite. Those with a higher risk appetite can opt for dynamic bond funds, where a fund manager can alter your portfolio in response to market trends, or credit risk funds, which invest in bonds that are of a relatively lower credit rating but can potentially yield high returns.

Investment amount: A key difference between debt funds and fixed deposits is that the former allows you to choose between a lumpsum investment or regular instalments (with a Systematic Investment Plan). This is beneficial when you are just starting your investment journey or are looking to cultivate a saving habit. Fixed deposits, meanwhile, only accept a one-time investment.

Conclusion
When evaluating debt funds vs fixed deposits, it is advisable to consider the merits and demerits of each and take your risk appetite and investment goals into account. While FDs carry almost no risk and have low but assured returns, debt funds carry a low-to-medium risk but can potentially yield higher returns. They also offer portfolio diversification opportunities and allow you to invest in small instalments if you do not have a lumpsum. You may also consider consulting a financial advisor or distributor to plan your investment strategy.

FAQs

What role do interest rates play in the performance of FDs or debt funds?

FDs and Debt funds are impacted by the interest rates. FD interest rates are fixed in nature however debt fund returns are impacted by the changes in interest rates in the market.

How liquid are FDs and debt funds? Can I access my funds whenever needed?

As the name suggests, fixed deposits are locked in for a particular period. Breaking an FD before its maturity might incur some penalties. However, debt funds are more liquid as they can be redeemed anytime. But certain funds may have some exit load for redemption hence read all scheme related documents carefully.

Which investment options can offer me better returns?

FDs are generally a safe, definite, and minimum risk-based investing tools. However, debt funds can provide with a higher return in the longer run but they are subjected to risks and market fluctuations.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.