Traditionally, a lot of people would keep all their savings in their saving bank accounts or fixed deposits to safeguard their future. However, this simple mechanism of saving doesn’t compound the money invested. Investing in debt funds or FDs or equities is a topic that is widely debated upon and though there are a plethora of investment options as well as popular opinions on which is the best investment avenue, the choice of investment lies in the hands of the individual. So, let’s have a look at debt mutual funds and how they differ from traditional investment instruments.
Debt Mutual Fund – What is it?
A debt fund or a fixed-income fund is one where a major chunk of your funds are invested in fixed-income securities such as debentures, government securities, corporate bonds, and the like. This helps to minimize the risk with reduced volatility, thereby making it a fairly stable avenue of investment for that chunk of the money where you don’t want to take a risk. There are a variety of debt funds that could be considered as investment options based on the time horizon, investment goals, etc.
Investing in Debt Mutual Funds Over Traditional Instruments – The Differentiating Factors
The most traditional investment instrument considered by most people is Fixed Deposit or FD. Debt mutual funds are very similar to FDs, but there are a few subtle differences. Let’s have a look at some of these differentiating factors.
(i) Tax efficiency
In a debt fund, taxes are levied only in the year of redemption and not prior to it. Tax can be paid on the proceeds of redemption irrespective of whether it is a complete or partial redemption. Short Term Capital Gains or STCG tax is applicable if the mutual fund units are held for a duration of fewer than 3 years, whereas Long-Term Capital Gains or LTCG tax is applicable on units held for 3 years or longer. LTCG also permits indexation benefits which try to reduce the hit of inflation by getting the purchase price at par as per the CII or the Cost Inflation Index. This gets the effective tax in the case of LTCG down to about 10-15%.
On the other hand, in an FD, the interest will be taxed during the period of investment as well as on maturity. The interest earned on an FD is added to the income of the taxpayer annually and is taxed as per the investor’s income tax rate. Even in the case of a cumulative FD, banks do deduct the TDS depending on the interest accrued in the year. This is one of the reasons why people invest in a debt mutual fund, especially if one of their important goals is to reduce taxes.
(ii) Liquidity and Lock-in Period
A debt fund does not come with a lock-in period. However, note that a few debt funds have an exit load, i.e., a charge for withdrawal of your funds for a certain amount of time after investing. This is normally quite short, keeping it to about 1 week or maximum a month. Only in case of longer durations, like Short Term Debt Fund, Medium Term, etc the exit load is also for a longer period.
However, a debt mutual fund offers liquidity where the investor can withdraw their money, even partially, anytime from the fund. On the other hand, FDs have a lock-in period. And in case you wish to withdraw from this prematurely, a penalty is charged by the lender.
(iii) Stability & Risk
A debt mutual fund invests your money in debt as well as money market instruments such as Government bonds, certificates of deposits, commercial papers, corporate bonds, etc. Debt funds come with two types of risk – credit and interest rate. Credit risk is based on the underlying securities borrower quality and credit rating. This metric is a reflection of the reliability of the borrower not defaulting on interest or principal repayment. Interest rate risk is based on the fund’s duration and the possibility of interest rate in the economy fluctuating during this time. For instance, a debt fund where the investment is made in money market instruments will have low-interest rate risk, whereas funds having long maturities will come with a high-interest rate risk.
On the other hand, on maturity, an FD will pay the investor the principal in addition to the accrued interest. So, if these two instruments are compared, one would feel that an FD is free of risks as the bank would assure the safety of capital. But there is a catch. Till now, we Indians truly believed that the guarantee in and FD holds absolutely true. However, the case of Yes Bank shows us that even in FD there is an element of risk. Today, there is a high variance in the interest rates charged by different banks on FD and this is a reflection of the risk as measured by the market in keeping your money with those banks. Hence, while the risk in debt funds is more dynamic and updated more frequently by being marked to the market, FDs are not free of risk either as often assumed by investors.
A Debt mutual fund allows investors to opt for the Systematic Transfer Plan (STP) where money can be moved to different mutual funds. In this manner, debt funds can be a good instrument to park money and bifurcate smaller amounts to equity mutual funds over a longer period. Apart from this, debt mutual funds also allow for a Systematic Withdrawal Plan (SWP).
One of the attractions of FDs is the option of a shorter duration of interest credit. In debt funds, this can be done more flexibly by assuming a certain withdrawal rate and initiating SWP at a pre-defined frequency. In the case of FD, the entire interest amount is liable to full taxation. In the case of a debt fund, only the gains on the withdrawn amount are taxed. This yet again makes debt funds much more flexible and tax-efficient.
Debt funds do not have a fixed rate of return, but the return is variable in nature, as they are linked to the market. If we look at the returns offered by debt funds in contrast to those offered by FDs over the last few years (the tenure of both being the same), you will observe that debt funds have been outperforming the FDs.
On the other hand, FDs offer investors a fixed rate of interest over the tenure of the FD. The interest compounds on a quarterly basis. However, over the years, the rate of interest of FDs has been seeing a decline, and some of the major banks offer a rate in the range of 5.1 – 5.4%.
Debt funds are quite an attractive option for those who want an investment option that has low- moderate risk. In contrast to an equity fund, the investment risk in a debt fund is quite low. Also, it is a good way to diversify your portfolio and balance out the risk, if the portfolio has a high level of equity. So, if you are on the lookout for some stable income, limited market risk exposure, in contrast to equity, then debt funds are a great investment avenue. A wide range of debt funds are available to choose from based on the time horizon and investment goals including liquid funds, fixed maturity plans (FMPs), ultra-short-term debt funds, etc. As an investor, bear in mind that, investing in a debt fund must be done post considering factors such as risk involved, the returns, the expense ratio, investment horizon, taxation, and financial goals. Happy Investing!