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Mutual Funds - Difference between bank Deposits and Debt Funds

17 Aug 2016

Introduction

The majority of investors consider debt fund as an alternative to the fixed deposits or as a rival to the bank’s fixed deposit. One of the reasons for this misconception is because due to their similar serving nature in the portfolio. But in reality this is not so. There are some crucial differences between the two which every investor should be familiar with. The preliminary differentiation comes in the segment of - safety and taxation, ultimately affecting the returns.

Fixed Income		Debt Fund
How to invest?	FD are offered by most of the banks	You could visit or contact a Mutual Fund house when required to invest in a direct plan Also, one can also invest online through brokerage houses, like ICICI, Kotak etc., or through agents. However, this will charge commission around 0.5 per cent.
Liquidity	Moderate:Generally, premature withdrawal is allowed but it usually comes with a penalty of 1 per cent on the interest rates for which the deposit is kept An investor can seek a loan against FD	High: Redemption can be made any day. Usually, there are no charges for redemptions after 1 year. However, an exit load of 1 per cent is generally applicable if the units are redeemed before 1 year
Taxation	As per the current tax slabs (10, 20 or 30 percent) If your interest income exceeds 10,000 a year, the bank will deduct 10.3% from this income	Minimum 10 per cent flat or 20 per cent with indexation (explained earlier)
Returns	Interest rates on bank fixed deposits (FDs) have touched 7.5-9.0%	The average short-term debt fund has given 9.8% returns in the past year, some long-term bond funds have shot up by 14-15% during the same period. However, returns in the short term could also be negative
Commission/Charges	NIL	A MF usually has a fund management charge of around 0.5%. This can be reduced by investing in direct plans. However, if you have invested through a broker, the broker may also charge you around 0.5%
Interest Rate	Fixed for the entire tenure (Present 7.5-9.0%)	MFs are actively managed and the fund usually seeks to generate returns from various instruments offering different interest rates as per the interest cycles
Underlying Assets	NA	Government bonds, treasury bills, bank bonds, corporate CDs, etc.
Guaranteed Returns	Yes	Theoretically, no, as these funds are linked to the market and subject to interest rate and credit risks. However, chances of a default are very minimal and hence debts funds are practically safe and give positive returns.

Example:

Let’s understand this with an example: Suppose you had invested 10,000, three years back, i.e. in 2011-12, into a fixed deposit offering an interest rate of 10% p.a. and also in a debt mutual fund, offering same 10% p.a. return for 3 years.

	Fixed deposit (FD)	Debt fund
Invested amount	10,000	10,000
Interest after 3 years	3,331	-
Capital gain after 3 years	-	3,331
Indexed cost*	-	13,044
Taxable capital gain (13,331 - 13,044)	-	287
Tax to be paid:	As per income slab	20% after indexation
10% Slab	333.1	57.4
20% Slab	666.2	57.4
30% Slab	999.3	57.4
Overall Return (20% slab)	12,664.6	13273.6

*Indexed cost refers to the cost of your investment, if you were to invest the same, on the date of selling it. It is calculated using the Cost of Inflation Index (CII).

Conclusion

The goal of any investor is to make wealth to fulfill their needs in the future. For an investor with low-risk appetite, protection of investment amount is very important. However, there should be financial investments for liquidity during emergency. You also need investments for the means of capital appreciation.

If you seek capital appreciation and tax benefits, along with reasonable safety on capital, then debt funds are the better than fixed deposit.
If it is the question of capital safety to investor then fixed deposits would be the right option.

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