Considering the cyclical nature of an economy, the one thing investors are always worried about is the risk involved, when it comes to getting their returns on investment.
While investing money via a Fixed deposit (FD) has been the go-to for most investors in the past, a significant shift to investing money via Debt Mutual Funds has been noted of late.
For the uninitiated, there is a big difference between debt fund and fixed deposit. Here, we explain both to help you understand which is your best investment option.
The first thing to address here is to address the very meaning of investing via a fixed deposit and investing via a debt fund. When you invest money via a fixed deposit, you put forth a large sum of your money in your registered bank for a fixed tenure, at an agreed rate of interest.
At the end of this tenure, you are then guaranteed a return of the money you had invested, along with the compounded interest. Debt funds, on the other hand, are a form of mutual funds, which invest the money you put forth into fixed income securities like bonds and treasury bills.
Debt funds offer potential investors a variety of mutual fund categories through which they can invest, and also offer them funds through which they can invest in short, medium and long-term bonds.
So, which best investment option should you look towards?
There are various factors that need to be considered while taking this decision. To help you take a well-calculated investment decision, here’s a breakdown of the popular Debt Funds vs FD debate.
Difference Between Debt Funds and Fixed Deposit
1. Rate of Returns
Let’s begin with the most determining factor for investors–which investment option will bring them the highest rate of returns? Fixed deposits usually offer guaranteed returns on investment, irrespective of the market performance.
However, the returns are usually at a fixed rate, unlike debt funds. Which means, that if the rate of interest falls, an investor will still only get back a fixed amount based on a fixed rate of interest, whereas in a debt fund, an investor will get back a higher sum since the fund depends on the current rates in the market, among other things.
Debt funds do not have a fixed return, which is why many market experts believe that they have the potential to offer higher returns than fixed deposits.
As mentioned above, debt funds tend to profit when the overall interest rates in the market go down. This is due to the fact that debt funds hold things like government bonds and corporate debt in their portfolios, so when the rates go down, the prices of these debt instruments go up as there is an inverse relationship between the rates and bond prices.
However, there is a risk involved when it comes to the rate of returns that debt funds might bring an investor. Since some debt funds rely on bond market volatility, a big risk is involved in this kind of an investment, since the rate of returns would depend on the performance of the market, which could go through low spells.
It is a big reason why this kind of investment is usually opted for by big investors willing to accept greater risks. Irrespective of market volatility, the interest rates on fixed deposit schemes remain unchanged, and it also allows investors to calculate ahead, the amount of money they can expect to get back.
Simply put, while debt funds can offer an investor a higher rate of returns, a fixed deposit assures the investor more or less a fixed rate of return.
Another major factor that an investor needs to consider, is liquidity. This is where debt funds have an advantage over fixed deposits, because debt funds allow you to give a redemption request, following which the funds are sent into your account within T + 1 days. You are usually only charged an exit load fee for certain kinds of debt funds.
When it comes to fixed deposits, on the other hand, about 1 percent of your returns get cut if you withdraw your money before the completion of your term. You either have to break into your fixed deposit account or take a loan against the fixed deposit account–which is a costly affair.
When it comes to taxation it’s really important to know the best tax saving mutual funds to cut down your taxes, those investing money through a fixed deposit have the interest they earned, added to their annual salary, following which they are taxed according to the income tax slab that they fall under.
For those investing in debt funds for a period under 36 months, a similar kind of taxation process in India is followed through. However, the debt fund taxation for those holding debt funds for more than 36 months is different, because they can receive the benefits of indexation on the returns they get back.
This means that the cost at which they are initially making their investment is revised up in order to account for inflation, as a result of which the taxable capital gains get lowered, thus reducing their tax liability.
An advantage that debt funds have over fixed deposits in the Debt Fund vs FD debate, is that they allow for more flexibility. Instead of placing all the eggs in one basket, the debt funds invest money into diversified portfolios, thus countering the scary prospect of the security defaulting or downgrading by any chance.
In addition, the flexibility of a fund manager of debt funds is also much greater when it comes to asset selection and allocation. He or she can shift the average ratings and maturity of the diversified portfolios. This is one of the main reasons why debt fund investments accrue higher returns.
Fixed deposits are less flexible, with investors running the risk of losing a large sum of money if things go wrong.
Those investing in debt funds can usually be assured of complete transparency for the whole process-they can retrieve information regarding things like the calculation of net asset value, expense ratio and the portfolio as a whole.
In contrast, a fixed deposit investor barely receives enough information regarding his or her investment, since their money is usually looped together with other deposits and is lent as commercial loans. As a result of this, investors often do not get a chance to predict possible red flags or to opt for premature withdrawal, if things go wrong.
At the end of the day, there will be many arguments both for and against debt funds and fixed deposits.
While these factors are instrumental in helping investors make a decision, the final call completely relies on his or her needs, return expectations, and understanding of risk.