Debt MFs vs FDs: Which gives better returns?

The question of debt mutual funds verses fixed deposits has been going on for a long time. Which one serves better for the conservative investor? InvestmentYogi takes a close look and breaks it down, giving you the details you need to make an informed choice.

For years now, a risk averse investor has considered fixed deposits as the safest bet. But with more mutual fund houses floating pure debt funds, which guarantee a fixed income and assure better returns, a conservative investor now has more choices to consider.

A fixed deposit is a secure investment option floated by banks and financial institutions. It offers a pre-determined rate of interest over a fixed time period. A debt mutual fund is a professionally managed fund, which invests money in government securities, bonds, money market instruments and corporate deposits.

They include a small percentage of equity investment of around 10 per cent in their portfolio to give investors capital appreciation. Hence, debt funds are associated with little or limited investor risk.

While choosing between capital appreciations and guaranteed returns it pays to compare the following key features of the two products.

Return on investment

Fixed deposits: Banks offer an assured fixed rate of return on maturity. Currently the rate of return varies from 3.5 per cent to 8.5 per cent depending on the maturity period. Interest is compounded quarterly and the proceeds are paid on maturity.

Debt fund: The rate of return of a debt fund is not assured and is governed by movement in interest rates and money market conditions. Any fluctuations in prices or interest rate impact the NAV of the fund.

Fixed deposit: Most banks allow premature withdrawal of the amount invested, before the actual maturity date. The interest would be calculated on the basis of the number of days the amount stayed invested with the bank. For larger amounts, banks have surrender charges or penalties.

In such cases, money would not be made available without penalties or until the fixed deposit matures.

Debt funds: Liquidity is similar to individual stocks or equity mutual funds which allow investors to liquidate their units in the market as and when they require. On redemption, one can expect to receive the amount in a day or two from the fund house.

The amount received would be based on the NAV of the fund as on the date of redemption.

From the tax angle, in the long run, a debt fund seems more friendly than a fixed deposit.

Fixed deposits: The interest earned on fixed deposits is added to the total income, and then taxed at applicable slabs. Also, if the total interest earned on all fixed deposits in a bank is greater than Rs 10,000 in a financial year, a tax of 10.3 per cent will be deducted at source by the banks.

Debt mutual funds: The short term capital gain of a debt fund is added to the income and then taxed at applicable slabs. For long term capital gain tax, it is calculated as 10 per cent without indexation or 20 per cent with indexation.

Dividends received on a debt mutual fund are tax free in the hands of the investor. However, a dividend distribution tax of 14.16 per cent is to be paid by the asset management company (AMC). Though this tax is not paid by the investor, the burden of this is eventually passed on to the investor by the AMC, by declaring lower dividends.

Here is where a debt fund scores over a fixed deposit. The equity investment in a debt fund provides it an edge over a traditional fixed deposit. In the long run, changes in market condition increase in interest rates and with the professionalism of fund managers, debt funds manage to provide investors a better capital appreciation.

Risk factor

A fixed deposit assures the investor capital protection unlike a debt fund. With volatility in the market, the value of a debt fund may be eroded, resulting in low or sometimes even negative returns. Thus an investor may not receive the expected returns on redemption. Risk also arises from the credit rating or quality of the invested instruments.

A fixed deposit doesn't offer protection against inflation. If the inflation rises steeply during the tenure of a fixed deposit, the inflation adjusted return could be low or even negative. For positive returns, the interest rate of a fixed deposit should be much higher than the core inflation rate of the country.

Debt mutual funds have managed to generate returns that have surpassed this inflation rate thus providing positive 'real returns'.

Investment costs

Banks do not generally charge any management costs for a fixed deposit investment. Investing in debt funds cost the investor investment management fees and fund distribution costs, charged as a percentage of the investment value.

This is borne by the investor irrespective of the fund performance. Fund houses also charge an entry or exit load from investors during entry or exit from a scheme.

The goal of any investor is to accumulate wealth to fulfill future wants and needs. For a conservative investor, protection of principal is of utmost importance.

However, financial prudence lies in having liquidity for contingencies, as well as a means for capital appreciation.

If you seek capital appreciation and tax comfort, along with reasonable safety of capital, then debt funds score over fixed deposits.

On the other hand, if capital preservation is all that matters to you then fixed deposits would be the right option.

*One year returns: Debt versus mutual funds

One year fixed deposit rates as on August 18, 2010.

*Source: Websites of respective banks

One-year returns as on August 18, 2010 of a few open ended debt schemes.

*Source: www.valueresearchonline.com