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
4. Difference Between Debt Funds and Fixed Deposits
5. Factors to Consider Before Investing in Debt Funds
6. What Are the Benefits of Investing in Fixed Deposits?
7. Things to Consider Before Investing in FDs
8. Debt Funds vs Fixed Deposits: Which investment is right for you?

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 funds 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.

Difference between debt funds and fixed deposits

Debt mutual funds and fixed deposits (FDs) are common investment choices for those seeking relatively steady returns with lower risk. However, they differ in several key aspects. Here’s a comparative overview:

Debt funds:

Investment: Debt funds collect investments from multiple individuals to build a diversified portfolio of fixed-income securities such as bonds, treasury bills, and commercial paper.

Returns: Returns are influenced by market movements and the fund manager’s strategy, making them subject to fluctuations.

Liquidity: Debt funds usually offer relatively high liquidity, allowing investors to redeem their units on any business day.

Risk: Debt funds involve some level of risk, although typically lower than equity funds. The risk is affected by the credit quality and maturity of the securities in the portfolio.

Fixed deposits (FDs):

Investment: FDs are investment products from banks and financial institutions where a lump sum is deposited for a fixed term at a predetermined interest rate.

Returns: FD interest rates are fixed for the tenure, ensuring predictable returns.

Liquidity: FDs generally have limited liquidity, and premature withdrawals may result in penalties.

Risk: FDs are usually considered relatively low-risk investments, with deposits insured up to a specific limit by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Key differences summarized:

Feature	Debt Mutual Funds	Fixed Deposits
Investment	Diversified portfolio of fixed-income securities	Lump sum deposit at a fixed interest rate
Returns	Market-linked, can fluctuate	Fixed interest rate
Liquidity	High	Limited, penalties for early withdrawal
Risk	Some risk, influenced by market conditions	Low risk
Taxation	Returns taxed as per income tax slab	Interest income taxed as per income tax slab

Factors to consider before investing in debt funds

Investment horizon: If you have a short-term financial goal (e.g., within 1-3 years), consider debt funds with shorter maturities. These funds tend to be less sensitive to interest rate fluctuations. For longer-term goals, you might consider debt funds with a mix of maturities. While they may carry slightly more risk, they also offer the potential for higher returns over time.

Risk tolerance: Debt funds invest in bonds and other debt instruments issued by various entities. Credit risk refers to the possibility of the issuer defaulting on payments. Assess the credit quality of the fund's portfolio, as funds investing in higher-rated securities have lower credit risk. Interest rate risk refers to the potential decline in the value of the bond portfolio as interest rates rise. Funds with longer-maturity bonds are more susceptible to this risk.

Expense ratio: The expense ratio is the annual fee charged by the fund house to manage your investment. A lower expense ratio can significantly impact your net returns over time.

Fund manager's track record: Evaluate the fund manager’s experience and track record. A skilled fund manager can navigate market conditions and potentially deliver better returns.

Past performance: While past performance does not guarantee future results, it can provide insights into how the fund has performed under different market conditions. Consider the fund’s performance over various time periods.

What are the benefits of investing in fixed deposits?

Relatively low risk: FDs are typically considered relatively low-risk investments. Deposits with banks are insured up to a specified limit by the Deposit Insurance and Credit Guarantee Corporation (DICGC), adding a layer of protection against bank failures. This makes them suitable for risk-averse investors.

Predictable returns: FDs offer fixed interest rates for the chosen tenure. This predictability allows investors to estimate returns with a high degree of certainty, aiding in financial planning.

Simplicity: FDs are straightforward and easy to understand. Opening an FD requires minimal documentation, making them accessible even to those new to investing.

Various tenure options: Banks provide FDs with tenures ranging from a few days to several years. This flexibility allows investors to select a tenure that aligns with their financial goals.

Can be used as collateral: FDs can serve as collateral for loans, providing access to funds in times of need without liquidating the investment.

Things to consider before investing in FDs

Interest rates: Interest rates vary across banks and financial institutions. Compare offers before investing. Small finance banks and post offices sometimes provide higher rates, but assess associated risks.

Tenure: Choose a tenure aligned with your financial goals. Avoid locking funds for longer than necessary, as premature withdrawals incur penalties. If you anticipate needing funds soon, opt for shorter-term FDs or more liquid investment options.

Premature withdrawal penalties: Different banks impose varying penalties for early withdrawals. Check the terms before investing. Keep emergency savings separate from long-term FDs to avoid withdrawal penalties.

Bank’s financial health: Deposits are insured up to a certain limit by the Deposit Insurance and Credit Guarantee Corporation (DICGC), but assessing the bank’s financial stability is still wise. Consider the bank’s track record and reliability before investing.

Inflation: If inflation surpasses your FD’s interest rate, your real returns may be negative. FDs may not be ideal for long-term wealth creation due to inflationary impact.

Debt Funds vs Fixed Deposits: Which investment is right for you?

Choosing between debt mutual funds and fixed deposits (FDs) depends on your financial goals, risk tolerance, and investment horizon. Both options offer distinct features, making one potentially more suitable than the other.

Risk tolerance: If you prefer stable, predictable returns with minimal risk, FDs might be suitable. If you can tolerate some market fluctuations for potentially higher returns, debt funds can be considered.

Investment horizon: For short-term goals (e.g., 1-3 years), FDs offer stability. For long-term goals, debt funds may provide better growth potential.

Liquidity needs: If you need easy access to funds, debt funds offer higher liquidity compared to FDs.

Financial goals: If you require a lump sum at a fixed date, FDs might be a better option.

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.

Are debt funds riskier than fixed deposits?

Debt funds carry market risks, mainly interest rate risk. When interest rates increase, bond prices decline, which can reduce the NAV of debt funds. Fixed deposits (FDs), on the other hand, are not affected by daily interest rate fluctuations during their tenure, offering more predictability. However, both FDs and debt funds come with certain risks.

Which investment is better for tax savings: Debt funds or fixed deposits?

Neither debt funds nor FDs provide specific tax-saving benefits. Interest earned on FDs is taxed as per the investor’s income tax slab. Previously, long-term capital gains on debt funds after indexation were taxed at 20%, but now, gains from debt mutual funds, regardless of the holding period, are added to the investor’s income and taxed at the applicable slab rate. As a result, both are now taxed similarly.

Can I withdraw my money early from a debt fund or an FD?

Debt funds generally allow withdrawals with ease, though exit loads may apply depending on the fund and holding period. Fixed deposits (FDs) can also be withdrawn before maturity, but this often results in penalties, usually in the form of reduced interest. Liquidity terms differ, so it's important to review the specifics of each investment.

Which is a better option for short-term investments: Debt funds or fixed deposits?

For very short-term needs, such as a few months, FDs may be suitable due to their predictable returns and lower market risk. For slightly longer durations, like 1-3 years, certain debt funds, particularly those holding shorter-maturity bonds, can be considered. They may provide relatively higher returns than FDs but with slightly more risk. Assess your risk tolerance and investment horizon before making a choice.

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 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.