Bank FD vs Debt Mutual Fund Comparison
|Particulars||Fixed Deposit||Debt Mutual Fund|
|Initial Investment||₹ 10,00,000||₹ 10,00,000|
|Investment Period||3 Years||3 Years|
|Expected Return||5.50 %||7.00 %|
|Maturity / Redemption Amount||₹ 11,74,241||₹ 12,25,043|
|Interest Income / Capital Gain||₹ 1,74,241||₹ 2,25,043|
|Assumed Indexation Rate||NA||6.00%|
|Indexed Cost of Investment||₹ 10,00,000||₹ 11,91,016|
|Taxable Income||₹ 1,74,241||₹ 34,027|
|Applicable Tax Rate||30.00%||20.00%|
|Tax Payable||₹ 52,272||₹ 6,805|
|Post-Tax Returns (Rs)||₹ 1,21,969||₹ 2,18,238|
|Post-Tax IRR (%)||3.91%||6.80%|
*For simplicity in calculating LTCG, it is assumed that withdrawal from a debt fund is made after the end of the year. It is assumed that in the case of Fixed Deposit, the annual interest is re-invested at the same rate of interest, and income tax is paid at the end of the investment term. Mutual fund investments are subject to market risks, read all scheme related documents carefully. Returns are not guaranteed. The above is for illustration purpose only.
Comparison Between Fixed Deposit and Debt Mutual Fund
|Fixed Deposit||Parameters||Debt Fund|
|Low||Risk||Low to Moderate|
|A penalty is levied upon premature withdrawals||Early Withdrawal||Allowed with / without exit load depending on the scheme|
|No fund management fee||Investment Expenditure||A nominal fund management fee is charged|
|TDS applicable on Interest payment||TDS||No TDS on withdrawals for Resident Individuals|
|Interest is taxable as per the applicable tax slab on an accrual basis||Taxation||Capital Gains Tax on|
STCG as per applicable tax slab upto 3 years
LTCG @20% after 3 years
with indexation benefit.
If you ask most people in India, what words they associate with Mutual Funds, words like stocks, high risk, equity market, etc. will top the list.
That’s because while there is a growing awareness about why mutual funds are a good investment option, almost everyone thinks they are a way to invest in stock markets. This belief gets reaffirmed when someone is looking to invest. Since we all want high returns, the filtering is done from high to low returns even when we are investing for a short duration.
Well, there are Mutual Funds that invest in a variety of non-stock instruments like corporate bonds and, therefore, generate returns at a much lower risk when compared to equity funds. These Mutual Funds are called Debt Mutual Funds.
In this blog, we tell you everything you need to know about Debt Mutual Funds and why they should be part of your mutual fund portfolio.
What are Debt Mutual Funds?
A debt mutual fund is a fund that invests in a range of interest-bearing instruments such as Corporate Bonds, Treasury Bills, Government securities, etc.
While it might sound complicated, it isn’t. Let’s go back to the basics.
When a company needs capital (for growing the business or something else) – it has two ways to get that money – either it sells part of the company via stocks, where people buy that stock and become part-owner of the company – or it can borrow money from a financial institution.
The most common example of borrowing is from a bank. They take a loan from the bank, pay interest, and once loan tenure is complete, pay back the money. The bank doesn’t own any part of the company. It is just a lender.
Now, apart from the bank, the companies also have the option of borrowing by issuing Bonds. These bonds have a fixed maturity or tenure (can be as low as 1 day), and interest rate lender will get is defined. Till the maturity, the borrower pays interest amount, and the principal amount is paid back on maturity. Even the government raises money through bonds to fund its expenses.
These bonds are sometimes offered to retail investors directly, but mostly, this is used by companies to raise money from financial institutions, including Mutual Fund companies. Also, these bonds like stocks are bought and sold, and their value also changes. However, unlike the stock market, the bond market is not open to individual investors for transactions.
To summarize, when you invest in a Debt Mutual Fund, it takes your money and lends it to a company. The bank also does the same thing with your money, but they take a more significant cut from the interest they receive.
For instance, a bank might give you a 6.5% FD rate, take that money, and lend to corporate at 11-12%. On the other hand, mutual funds charge a minuscule amount, mostly in the range of .5% to 1.5% as the expense ratio of the fund’s value.
Now that we know the basics let’s look at how do debt funds work?
How Do Debt Funds generate returns?
As we mentioned above, the debt funds invest in bonds that pay interest. The company borrowing the money makes the interest payment on the predefined interest rate. So that’s one way the returns are generated.
The second is by price appreciation of the Bond. Since bonds are traded and their prices change, an increase in the value due to increased demand means a fund can sell them and make money.
How does the value of a bond increases or falls, you ask? The most known reason is due to a change in the interest rates in the market or even the news about an upcoming turn.
Let’s take an example – Suppose a debt fund holds a bond that is paying a 10% interest rate per annum. Now, if the interest rates in the economy fall, any new Bond coming in the market will give a lower interest rate, say 9%. And because of this, the demand for the old Bond giving a higher interest rate increases (as you can earn more from it). This leads to a rise in the price of the Bond and, subsequently, the NAV of the debt fund holding it.
What percentage of return comes from the interest income and what from this price appreciation and subsequently the risk a debt fund has are a function of which companies it lends to and for how long.
How Debt funds are different from Equity Mutual funds?
Equity Mutual Funds invest in companies by buying their stocks. So when you invest in them, you become part-owner of the company the fund puts money in.
The returns equity funds generated through a combination of selling a stock at a higher price and the dividend received from the company. So the returns you get are dependent on the performance of the company. If the company does well, the price of stock increase as more people want to own it, plus the company might share the profits with shareholders via dividends. If it doesn’t do well, you might lose money. So the risk is higher, but so are the rewards.
On the other hand, Debt Funds lend to corporates. When you invest in them, you become a lender to these companies, not owners. The returns are generated by the interest received and the price appreciation of the Bond. For this reason, the performance of the company doesn’t have much impact on the returns – as long as it doesn’t default, you will get returns. However, the returns will not be as high as Equity Funds.
That doesn’t mean there are no risks in Debt Funds.
What are the risks of investing in Debt Mutual Funds?
Yes. There are risks involved in investing. Be it equity or debt. However, the amount of risk is way lesser in debt funds when compared to equities. Within debt funds, there are categories with almost negligible.
There are two risks associated with Debt Mutual Funds – Credit Risk and Interest Rate Risk.
Let’s see what they are and how you can minimize them.
Interest Rate Risk
As mentioned above, the price of the bonds rises and falls based on the interest rates in the economy, and that is the first risk associated with debt funds.
In the above-mentioned example, the price of the Bond increased because its interest rates went down. But what if the interest rates in the market go up? New bonds will give a higher interest rate, and hence the existing Bond’s value will go down (due to low demand). Subsequently, the NAV of the fund will fall.
Since it is not possible to predict how interest rates will move, the best way to mitigate this risk would be to invest in those fund categories that lend for short duration to medium duration period. That’s because interest rates don’t change drastically in a short period.
The other risk is that the borrower defaults and doesn’t pay interest and/or principal amount back.
This risk played out sometime back when DHFL and IL&FS defaulted. The bonds issued by became zero value, and mutual fund investors had to take a hit because of this.
The best way to avoid this risk is to invest in the debt fund that lends to highly rated corporates. Ratings assigned by credit agencies like CRISIL are a good indicator of the financial health of these companies. AAA rating indicates the lowest credit risk.
One thing is worthy to note that since high rated borrowers are less risky, they also give you lower interest rates.
Why and How to Invest in Debt funds?
Debt Mutual Funds solve two purposes in any investor portfolio.
One, they help reduce overall portfolio risk as they help in diversification. Every investor – be it experienced or a newbie – should have some allocation to debt. It could be 20%, 30% or even more. This debt part of the portfolio provides a cushion when equity markets fall and bring stability to returns.
Second, debt mutual funds are a good alternative for your savings. The money you want to keep for a few days to cash you are accumulating for short term goals like vacations, buying a gift, etc.
However, to make sure you keep the risk in control, make sure you invest in debt funds by first defining for how long you want to invest and what is the risk you are willing to take.
Here is how you can approach investing in debt funds
|Investment Tenure||Fund Category (Debt)||Credit Risk||Interest rate Risk|
|1 day to 3 months||Liquid Funds||Very Low||Very Low|
|3 to 6 months||Ultra short Duration Funds||Very Low||Very Low|
|6 months to 1 year||Low Duration Funds/Money Market Funds||Low||Low|
|1 year to 2 years||Short Term Funds||Moderate||Moderate|
|Corporate Bond Funds||Moderate||Moderate|
|2 year to 4 years||Banking and PSU Funds||Low||Moderate|
|Corporate Bond Fund||Moderate||Moderate|
|3+ years||Medium Duration Funds||Moderate||High|
As you can see, Debt Mutual Funds are a great option for anyone looking to invest without taking the risk of equities. However, it is not just for low-risk investors.
Equity investors should look at debt funds to reduce overall portfolio risk by giving investments a cushion.