Should you use debt funds as alternatives to fixed deposits? We explain

While bank fixed deposit rates are making a comeback nowadays, many investors for some time have been looking at debt funds as alternatives to fixed deposits.

But is this the right way to look at debt funds? That is, as clear as FD alternatives?

Not completely.

Debt funds are not substitutes for fixed deposits fully. But they can be possible alternatives. Why I say this is because all debt funds are not the same. There are 15+ categories of debt funds and all of them are no true FD alternatives.

While it is true that debt funds have delivered better post-tax returns than bank FDs, let’s not forget how debt funds give higher returns. Unlike FDs, debt funds have a risk dimension as well which is the source of extra returns. This risk comes in many forms like interest risk, credit risk, etc. But to put it very simply, looking at debt funds as FD alternatives because they too are risk-free like FDs is not correct.

That said, let’s compare the debt funds and fixed deposits from different angles.

Better post-tax returns

As you already know, the FD interest is taxable every year as per the applicable tax slabs. So if you are in the 30% bracket and your FD is giving you 6%, then your post-tax returns are only 4.2%. This is where debt funds have an upper hand. For less than 3 years, the capital gains from the debt fund are taxed as per tax slabs.

But if you remain put in debt funds for more than 3 years, then the capital gains are considered long-term and taxed at 20% with indexation. And indexation lowers the actual tax liability by adjusting the purchase cost upwards and reducing the effective taxable capital gains.

Equally Safe?

We discussed this earlier as well. FDs are safe (unless your bank fails and RBI is unable to help – which is a very low-probability event). But debt funds are not risk-free. And the reason is that they need to take additional risks to generate higher returns than FDs. So even though the perception might be that these are risk-free FD alternatives, the reality is not that.

What about liquidity?

FDs have fixed tenure and if you need money before the completion of FD tenure, then you need to prematurely break your FDs. This might lead to lower interest income and penalties. But debt funds are different. You can withdraw and redeem your debt funds money whenever you want to. You can invest today and exit tomorrow as well. There is no lock-in and exit loads are also negligible.

That’s not all. You can also withdraw any amount from debt funds. That is, if you invest ₹1 lakh today and want to withdraw just ₹15,000 after 3 months, then you can do it. The remaining ₹85,000 remains invested. This is unlike FDs where you make an FD of ₹1 lakh and if you need ₹15,000 after a while, you need to break the full FD.

And if you were to ask which deb fund categories are best alternatives to bank FDs, then its best to stick with ultra-short duration funds, low duration funds and short duration funds. The interest rate risk in these categories is a lot less than what comes with high-duration funds. Also, if you pick schemes that have high-quality underlying papers, then you are sort of managing the credit risk to a large extent.

But if you are ultra-conservative and don’t want to take any unnecessary risk, then stick with bank FDs. For everyone else, debt funds can be considered as in spite of some risks, they can be reliably expected to deliver better post-tax returns if you remain invested for a sufficiently long period.

Dev Ashish is a SEBI-Registered Investment Advisor and Founder (Stable Investor). He provides fee-only financial planning and investment advisory services to small and HNI clients across India.