Before we get into this topic, here is some quick background on the taxation change. Capital gains from new investments in Debt Funds are now taxed as per your individual slab rates irrespective of the holding period. Previously, Debt Funds had a taxation advantage over FDs (gains from debt funds held for 3+ years were taxed at 20% post-indexation).
This change has put the taxation of Debt Funds at par with FDs. Therefore, the choice between Debt funds and FDs going forward will primarily be made on the merit of the product versus the taxation rate differential.
Now, let’s compare Debt Funds to Fixed Deposits and see which one fares better.
FD: When you invest in a fixed deposit, you are essentially lending money to a single borrower i.e. your bank.
Debt Funds: When you invest in a debt fund, your money is split and loaned to multiple borrowers. Eg: Central and State Governments, PSUs, Banks and Corporates. This leads to much better diversification.
Advantage: Debt Funds
FD: A premature withdrawal penalty is generally charged if you want to exit your investments early. It is also not possible to systematically withdraw money from your FDs.
Debt Funds: In most debt funds, the money can be withdrawn anytime without any exit penalty. Further, you have the option to automate your money withdrawals every month by setting up an SWP (Systematic Withdrawal Plan).
Advantage: Debt Funds
Also Read: From New Tax Regime to Old, avoid these top 9 Income Tax Return (ITR) filing mistakes in 2023
FD: FD returns are taxed every financial year. This is regardless of whether you choose to receive interest every year or on maturity.
For example, let’s say you invest Rs 10 lakh in a 5-year FD at 6% interest. Here you will have to pay at least Rs 18,000 in tax (assuming 30% slab) every year. Plus, the regular interest payouts and TDS deduction in FDs also may affect compounding.
Debt Funds: Unlike FDs, debt fund gains are taxed only when you redeem. This allows better compounding of returns over the long term.
Source: FundsIndia Research/ Tax Slab is assumed to be 30%
In debt funds, you also have the option to plan your redemptions in such a way that your tax outlay is reduced. You can lower the tax amount to as much as zero if you use debt funds for post-retirement goals (similar to EPF). All these result in better compounding outcomes in the case of debt funds.
Advantage: Debt Funds
FD: In fixed deposits, the credit risk (read as the chance of not getting your money back) generally tends to be low, especially for large banks. Moreover, the overall bank deposits of up to Rs 5 lakh are insured – which adds to the comfort.
Debt Funds: Here the credit risk varies from low to high. But this risk can be minimised to a large extent by choosing debt funds with high credit quality.
Advantage: Fixed Deposits
FD: The returns are predictable and can be known at the time of investment. There are no fluctuations in your returns unless the bank faces some issues.
Debt Funds: There can be some fluctuations in your returns due to yield movements. The return predictability is therefore lower compared to FDs. However, this has also been addressed to a large extent by Target Maturity Funds.
Advantage: Fixed Deposits
Also Read: What is the ideal Fixed Deposit tenor for senior citizens and others amid interest rate hikes?
FD: The returns are fixed
Debt Funds: Debt funds provide scope for higher returns if interest rates fall and vice versa. Bond prices rise when yields fall (positive for debt fund returns) and bond prices fall when yields rise (negative for debt fund returns).
In the last two decades, debt funds have largely outperformed FDs over 3 year periods with an average outperformance of 0.5%. This outperformance has been much more significant during phases where yields have declined.
Source: FundsIndia Research, MFI, Investing.com, RBI; Short Duration Debt Fund Returns are based on average 3Y CAGR of the three largest funds in the category with 20+ year track record; FD Returns are based on historical FD rates as published by RBI; All returns are on a pre-tax basis
We believe that we are close to peak yield levels of the current interest rate cycle. Any fall in yields could lead to better returns from your debt funds in the near term.
Advantage: Debt Funds
Here is a quick summary of the above
Source: FundsIndia Research
If fixed returns at little to no volatility are your priority, then you can go for fixed deposits. But if you are willing to tolerate mild volatility, Debt funds are clearly better than FDs despite the taxation changes.
This is because Debt funds provide the potential for extra returns when interest rates fall, better compounding as returns are taxed only during withdrawal, flexibility to withdraw anytime without penalties, and better diversification.
You can prefer debt funds with
High Credit Quality (>80% AAA exposure)Short Duration (investing in 1-3 year segment) or Target Maturity Funds (investing in 3-5 year segment)
The author of this column is Shrinath ML, Senior Research Analyst, FundsIndia
Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of https://www.financialexpress.com
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