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Why debt funds will continue to score over fixed deposits

05 Jan 2023

For a very long time, bank Fixed Deposits were the hottest product in the market for the conservative  retail and HNI investors. The reasons were not far to seek. Indian interest rates were relatively high and it was the lure of security of a bank that really attracted people to lock up their money in bank FDs. In other words, bank FDs had almost become synonymous with debt investments. Since the beginning of 2015, the RBI has cut repo rates by over 200 bps and the post-demonetization liquidity surge has ensured that most of these rate cuts have been transmitted. Banks, therefore, had no choice but to cut the rates payable on FDs to match it with the yield on loans. All this has led to the rise of debt funds as an alternative to bank FDs. What does this mean for FDs and will this trend sustain?

Bank FDs are hardly paying anything net of inflation..
While the monthly CPI inflation may be around the 3.2% mark, the average sustainable inflation is in the region of 4-5% with occasional spikes not entirely ruled out. With banks paying around 6.5% on their FDs, most FD investors are left with a very small margin of safety with respect to their real returns. Lower returns on debt have been the trend the world over and that trend is unlikely to change in the near future. It only means that interest rates may either be headed downward or flat, at best. With inflation likely to trend higher due to a combination of higher food prices and steeper oil prices, the margin of safety on bank FDs is likely to remain under pressure.

Bank FDs do not benefit when rates go down..
This is a unique advantage that debt funds enjoy over bank FDs. Debt funds typically hold government bonds and corporate debt in their portfolios. When rates go down the price of these debt instruments tend to go up due to the inverse relationship between rates and bond prices. When bond prices go up, the NAV of the debt fund also goes up. It has been observed that in a scenario wherein interest rates are being cut, the debt funds tend to outperform FDs by a huge margin. As a holder of bank FDs, you are indifferent to the movement of rates as the value of the FD remains the same. On the other hand, the value of your debt fund portfolio sees smart appreciation during this phase.

More flexibility to the fund manager and greater transparency for the investors..
These are two unique advantages that are available in a debt fund but not in a bank FD. As an FD investor you really do not know what is happening to your investment. Your FD money tends to get cumulated with other deposits and is on-lent as retail and commercial loans. On the other hand, when you invest in a debt fund, there is complete transparency on the portfolio disclosure, the calculation of NAV, the expense ratio etc. Most of these are fairly opaque in a bank FD. Secondly, the fund manager of a debt funds has much greater flexibility. For example, the fund manager, can tweak the credit rating of the portfolio, shift the average maturity and duration of the portfolio, shift between variable and fixed rate structures etc. This flexibility that debt funds offer is one of the main reasons why they have been able to earn much higher returns compared to bank FDs.

Don't forget the tax advantage of debt funds..
One of the big differences between a bank FD and debt funds is the tax treatment. Interest on bank FDs are taxed at your peak rate of tax. So if your FD has a yield of 7%, then your actual post-tax yield is just 4.9% (considering 30% tax bracket), which is just about sufficient to cover the cost of inflation. Also, bank FDs are subject to tax deduction at source (TDS) if the annual interest payable is more than Rs.10,000/-. On the other hand, debt funds offer 3 key advantages on the tax front. Firstly, the dividends paid out to the investor are entirely tax-free in the hands of the investors. Secondly, there is no TDS on debt funds in case of resident Indians and it is only applicable in case of NRIs. Lastly, debt funds also have an advantage in terms of capital gains. A debt fund that is held for more than 3 years is classified as a long term capital gain and is taxed at the rate of 10% without indexation or at 20% with indexation. This substantially improves your post-tax yield on debt funds.

Over the last few years debt funds are increasingly emerging as a viable alternative to bank FDs. As investors are increasingly realizing and appreciating the merits of debt funds over bank deposits, the shift is likely to get further accentuated!

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