Debt funds vs fixed deposits: Here are seven reasons why you should invest in MFs

Most likely our parents and even most of us grew up partly on a diet of bank deposits, fixed deposits (FDs) and insurance policies. For the more adventurous types, there was real estate. But the basic logic was that the bank FDs are safe because the public sector undertaking (PSU) banks will not shut the shop. They were also attractive because the FDs used to pay in excess of 10 percent at one point of time. That was when India's interest rates were relatively high and it was the lure of security of a bank that really attracted the people to lock up their money in bank FDs. In short, bank FDs had become synonymous with debt investments.A lot has changed in the last 20 years. Rates have been cut, debt funds have emerged as a viable alternative, FDs are losing the tax game and they provide limited flexibility. Let us look at the seven key reasons why mutual funds have emerged as a viable alternative to bank FDs. Of course, we shall largely compare bank FDs with debt funds to make the comparison meaningful. Occasionally, we shall also use equity funds to underscore the tax edge.Why mutual funds offer a better alternative than bank FDs?1) The consumer price index (CPI) inflation is a key factor today. The normal inflation has been in the range of 4-5 percent and even the Reserve Bank of India (RBI) expects it to sustain at that level. With banks paying around 6-6.5 percent on their FDs, most FD investors are left with a very little margin of safety with respect to real returns. This trend is prevalent globally and not only in India.[caption id="attachment_5222251" align="alignleft" width="380"]

Representational image. Reuters[/caption]2) The FDs do not benefit when the rates go down in the market. This is a unique advantage that the debt funds enjoy over the bank FDs. Debt funds hold government bonds and corporate debt in their portfolios. When rates go down, the price of these debt instruments tends to go up due to the inverse relationship between rates and bond prices.3) On the liquidity basis, debt funds are surely more liquid. You can give a redemption request and get the funds back into your account latest by T+1 day. To that extent, they are almost like near cash. Of course, be cautious about the exit loads. On the other way, the bank FDs are not that liquid as you have to either break the FD or you can take a loan against the FD, which is available over the counter. But that still is a time-consuming formality and the FD loans have a cost attached to it. Debt funds surely score on the liquidity front.4) Transparency is another big advantage that debt funds have over the FDs. As an FD investor, you really do not know what is happening to your investment. Your FD money is cumulated with other deposits and is lent as retail and commercial loans. When you invest in a debt fund, there is complete transparency on the portfolio disclosure, the calculation of net asset value (NAV), the expense ratio etc. These are fairly opaque in a bank FD.5) Then we come to the flexibility that the fund manager has compared with the bank. The fund manager of debt funds has much greater flexibility in asset selection and asset allocation. A bank FD does not have any of these.6) Even tax-wise, the debt funds are more efficient than the bank FDs. For example, the interest on bank FDs is taxed at your peak rate of tax. If your FD has a yield of 7 percent, then your actual post-tax yield is just 4.9 percent (considering 30 percent tax bracket), which just about covers the cost of inflation. Debt funds also have an advantage in the taxation of capital gains. Debt funds held for more than 3 years are classified as long term capital gains and taxed at the rate of 20 percent with indexation. This substantially improves your post-tax yield on debt funds.7) Finally, let us compare the equity-linked savings scheme (ELSS) and long-term bank FDs, since both are eligible for exemption under Section 80C of the Income Tax Act. Here again, mutual funds have the advantage. The lock-in period is just 3 years as compared to 5 years in case of FDs. Secondly, the ELSS can give the benefit of wealth accumulation, which is non-existent in case of the bank FDs.Debt funds are increasingly emerging as a viable alternative to bank FDs. In fact, investors increasingly prefer liquid funds over savings accounts and debt funds over the bank FDs. As investors realise and appreciating the merits of debt funds over the bank deposits, the shift get more pronounced. However, the decision to invest between a bank FD and a mutual fund will always depend on the investor’s risk capacity.(The writer is chief sales officer at Angel Broking)