How often do we see investors mulling between debt funds and fixed deposits (FDs)? While both are relatively stable investments compared to equities, they are not quite alike when it comes to the constituent instruments and expected returns from them. Most debt fund instruments have a large exposure to government securities (G-Secs) though some also resort to putting money in private and institutional debt to earn better returns. For most Indian investors, investing starts with the simple innocuously looking bank FDs before they gradually move to alternative earning sources like mutual funds, gold, real estate, etc.
Are bank FDs worth the wait?
The continuous streak of repo rate hikes by the Reserve Bank of India (RBI) has prompted many banks and financial institutions to enhance the interest rates on their FDs too. For example, Punjab & Sind Bank (PSB) has upped its interest rates to 8.10 per cent on FDs of less than ₹2 crores. This means the bank will now offer interest rates ranging from 2.80 per cent to 6.25 per cent for deposits with maturities ranging from a week to a decade. Other banks and financial institutions are offering more interest on FDs, thus, prompting many people to shift to these traditional investment options.
However, irrespective of how alluring these FDs look, are they worth the time and expectations of investors considering the taxation impact? The impact of the tax is felt most when these FDs mature and the amount is redeemed and credited to the bank account. Apart, not many investors are aware that the income from FDs is taxable every year irrespective of the investment horizon, thereby, explaining their growing popularity.
How have debt funds fared to date?
The resulting lower rates have resulted in lower yields, which may not be enough to beat the effect of inflation in the long run. With money being devalued with each passing day, it makes sense to change your outlook towards investments and assess if debt funds can be a better option when contrasted with bank FDs.
Assuming how many investors regard debt funds as similar to bank FDs and hold them for a medium period, it is best to look at the following table that lists various medium-duration funds along with their three-year and five-year returns.
| Name of the fund | Three-year returns (in %) | Five-year returns (in %) |
| Aditya Birla Sun Life Medium Term Plan | 27.92 | 34.63 |
| ICICI Prudential Medium Term Bond Fund | 9.76 | 20.07 |
| SBI Magnum Medium Duration Fund | 8.31 | 19.26 |
| Axis Strategic Bond Fund | 9.28 | 18.92 |
| HDFC Medium Term Debt Fund | 8.53 | 18.38 |
| Kotak Medium Term Fund | 8.49 | 17.02 |
| IDFC Bond Fund - Medium Term Plan | 5.48 | 14.61 |
| UTI - Medium Term Fund | 7.79 | 12.13 |
| Baroda BNP Paribas Medium Duration Fund | 6.04 | 10.00 |
| Source: MoneyControl | ||
Where are the tax incentives?
Compare the interest rates on bank FDs and debt funds and you will realize how debt funds may be an interesting addition to one’s investment portfolio. On average, debt funds offer yearly returns of 10-15 per cent with some also exceeding 20 per cent returns depending on the fund manager’s outlook and performance. A lot also depends on the fund you invest in, which is why you must be aware of the benefits and inherent risks before putting money in any fund.
As an investor in a debt fund, you not only earn interest on your bonds, but you also earn capital gains when bond prices rise due to falling interest rates. Additionally, debt funds are highly liquid and can be monetized quickly. However, the biggest advantage debt funds have over bank FDs is tax incentives.
Most bank FDs have not earned more than six per cent returns in the past unless there has been a sudden rate hike by the RBI or barring exceptional circumstances. Apart from the yields on the lower end, FDs also have an inherent disadvantage on the tax front.
Dev Ashish, Founder, Stable Investor says, “The interest (or returns) from bank FDs are taxable and are added to the depositor’s annual income and taxed according to the applicable tax slabs. Also, the banks will deduct taxes at source (TDS) at the time they credit the interest to your account, and not when the FD matures. This is important to understand and it offers a ground to compare with debt fund taxation. So, if you have an FD for four years and you have chosen the cumulative option to receive the interest at the end of the four-year tenure, then you would still need to declare the FD interest income every year, as your bank will be deducting TDS (if applicable) and depositing it under your PAN. So, you need to add the interest income to your total income in your ITR every financial year (even though, the interest may not be paid out as maturity is still some time away).”
Taxation of debt fund investments
Debt funds compared to bank FDs ensure a lot more tax benefits. This is because debt funds are not subject to TDS on the dividends paid, as the dividends are tax-free as they are paid to the investors. Of course, the issuance of TDS on dividends from debt funds is only relevant for NRIs.
CA Kanan Bahl, a financial educator and growth consultant says, “Debt funds are taxed at 20 per cent on gains after indexation if you sell them after 3 years of holding. However, if you hold FDs they're taxable at your slab rate which can be 30 per cent also. Basically, there are three tax demerits of using FD vis-a-vis debt funds. These demerits include:
- No indexation
- Taxable at slab rates (even if more than 20 per cent)
- Taxability arises every year on accruals even if you do not redeem the interest or break your FD.”
Benefit of capital gains
Not many investors are aware of the capital gain benefits from debt funds compared to bank FDs. Bank FDs are not subject to capital gains as they are always redeemed at face value. However, with debt funds, investors obtain from capital gains benefits too. To calculate capital gains, debt funds are treated as non-equity assets.
Vasudha Gupta, Finance Lead, CommsCredible says, “The bank FDs interest is only chargeable for tax however for debt funds, there can be a tax on interest or liable for calculation of capital gain depending upon the case. Senior citizen investors get a deduction of ₹50000 on FD interest which is not available on debt funds interest. The TDS on Interest on FD has a more specified amount limit than the TDS on interest on debt funds.”
Viral Bhatt, Founder, Money Mantra says, “Capital gains in bank FDs and debt funds are taxed differently in India. Bank FDs do not offer capital gains as the interest earned is considered income and taxed at the applicable tax rate of the investor. So, any gains in FDs are subject to tax as per the investor's income tax slab rate."
“On the other hand, debt funds are subject to capital gains tax. Capital gains in debt funds are categorized as short-term and long-term capital gains based on the holding period of the investment. If an investor holds the investment for less than three years, it is considered a short-term capital gain, and if held for more than three years, it is considered a long-term capital gain. Short-term capital gains in debt funds are taxed as per the investor's income tax slab rate, while long-term capital gains in debt funds are taxed at a lower rate of 20 per cent after indexation. Indexation adjusts the cost of the investment for inflation, reducing the taxable capital gains amount," he added.
“Investors benefit from capital gains in debt funds as they are taxed at a lower rate than the income earned from bank FDs. However, investors should keep in mind the risks associated with investing in debt funds and consult with a financial advisor before making any investment decisions,” Bhatt said.
When it comes to liquidity, debt funds are equally as liquid as bank FDs. This is a benefit available other than the high returns and tax benefits. Despite the interest rates going high, it is important to compare the pros and cons of investing in debt fund investments versus fixed deposits before deciding when, how and where to invest the money.
