Should You Choose Fixed Deposits Over Debt Funds Now?
Should you still invest in Debt Funds or just do Fixed Deposits ?
Should you still invest in debt funds or keep it simple and switch completely to fixed deposits.
This year in March the govt. gave a shocker to all us investors. They announced a change to the rules relating to taxation of debt funds.
Let us look at what it was before and what it is now.
Thus far, debt funds had both short term and long term tax. Short term tax was your slab rate, if you sold the fund in fewer than 3 years. Long term was 15% with indexation if you sold after 3 years.
With indexation, the effective tax rate was significantly low. You effectively got taxed only on gains you made over the inflation rate.
It made a lot of sense to invest in debt funds compared to fixed deposits. The risk of capital loss in debt funds can be higher than that in fixed deposits, the additional returns made it worthwhile.
What is the tax rule now
From April 2023, debt funds have no long-term tax and no indexation applicable. All debt fund returns will be taxed at your slab rate.
This equates the fund to fixed deposits in terms of taxation. If there is no reward for additional risk, does it still make sense to invest in debt funds.
Compounding
There is one difference between the two. In Fixed deposits the interest is paid out in monthly / quarterly / yearly periods. The bank typically deducts tax and puts the rest of the money in your account.
In the case of debt funds, the tax will be applicable only when you sell the fund. If you sell after 3 years, the tax will be applicable at the point of sale.
In the three years you would have accrued interest on your investment and that interest would accrue more interest. Therefore there is still some merit in keeping the debt fund investments. Of course how much differential in returns is worth the additional capital risk, is something for each of us to decide.
Variable Return Vs Fixed
Debt funds have a variable return.
The return you get from the fund is decided by multiple market factors. You can choose which type of fund, short term, gilt, etc. However the return is dependent on interest rates, macroeconomic factors and other external factors.
The Fixed deposit on the other hand, as the name implies, gives you the promised return for the duration of the deposit.
Fees
Debt funds are subject to fees, this takes away from the returns you earn on the fund. This would further slice any benefit the debt fund would have over FDs within a given period.
FDs don’t have any additional fees.
Risk to capital
Depending on which debt fund you choose, there is a risk to the capital. Of course investing in govt. bonds is probably the lowest risk you can choose, with commensurate low returns.
You can also choose to invest in debt funds which lend money to PSUs & Banks, this would still be low-ish risk while providing comparable returns. I usually look at valueresearch for rankings and past performance.
FDs also carry capital risk. Let us not forget PMC bank, Yes Bank and a few others. While the government might help depositors eventually get their money back, would you want to be in such a situation at all.
The RBI does insure your FD to a maximum of 5 lacs. However any more than that , the risk is borne by you. Here, investing in FDs with nationalised banks should be a safer option.
Liquidity
Both are quite liquid.
You can liquidate FDs instantly, of course there is a penalty if you don’t keep it for the duration you booked it for. This is in the form of a lower interest rate (some banks might have other penalties)
Debt funds can be sold and the money will usually hit your account in a couple of working days. There is no penalty here, but some might have an exit load for selling within a very short period.
What are FDs and Debt Funds used for ?
Please realise that you are using these only for capital preservation. You are unlikely to get high returns here, unless you invest in risky debt funds / bonds. The whole purpose of this part of your portfolio is to preserve capital. Also interest rates usually move inverse to stocks, though that hasn’t actually happened in this cycle much. This is a means to diversify your portfolio and preserve capital. To that extent as long as your post tax returns are higher than inflation you are doing well. This is not an area to be chasing returns.
In Summary
There is no tax advantage to investing in debt funds anymore
If you can lock-in good returns on FDs then it might make sense to do so right away. Banks are offering 7+.
If you have a medium term horizon and don’t intend to pull out the funds for five years or so, it might make sense to invest in debt funds.
If you are in a lower tax bracket today, then FDs might make sense; however if you expect your tax rate to come down in a few years, then debt funds might make more sense.
Of course be aware of the risk of capital loss, and invest with your eyes open.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
