Why Debt Funds Are Better Than FD?

Debt Mutual funds are the ultimate choice if you don’t want to deposit your savings in Fixed Deposit but still want safe and guaranteed returns. I used to invest in FDs but the interest rates have come down too much and it is difficult to beat inflation with the FD returns.

Debt Funds are Better than FD

It doesn’t mean we should put our money in any random investment plans. If we want a substitute to an FD then, that investment instrument has to be as safe as Fixed Deposit. When I look for a safe investment with a reasonable return rate, I don’t see any other better option than Debt Mutual Fund. I cannot deny that there are other options (like PPF and NSC) available, but you have to invest for a longer horizon to get benefits.

What Is a Debt Fund?

Debt Fund are the mutual funds that pool money from other investors and invest in various securities. Unlike equity funds, Debt Fund invests in fixed securities like company bonds (both government and private), treasury bills, and other secularized products. They are less volatile and provides study returns.

It would be safe to say, Debt Funds are safe investment than equity mutual funds and can be considered as an alternative to Fixed Deposit. However, it is not 100% safe and inflation impacts the overall return. Generally, debt fund performs well during the higher inflation compared to low inflation.

Debt Fund provides greater flexibility on the investment horizon and you can invest even overnight. There are many types of Debt Funds based on your investment horizon and risk appetite.

Types Of Debt Funds?

SEBI has categorized the debt funds into 16 categories based on your investment tenure.

Sr.
No.
Debt FundMaturity TenureInvesting Funds In
1Overnight FundovernightDebt Scheme
2Liquid Fundup-to 91 daysDebt and Money market
3Ultra Short Duration FundBetween 3 to 6 monthsDebt and Money market
4Low Duration FundBetween 6 to 12 monthsDebt and Money market
5Money Market FundUp to 1 yearMoney Market
6Short Duration FundBetween 1 to 3 yearsDebt and Money market
7Medium Duration FundBetween 3 to 4 yearsDebt and Money market
8Medium to Long Duration FundBetween 4 to 7 yearsDebt and Money market
9Long Duration FundGreater than 7 yearsDebt and Money market
10Dynamic BondAcross DurationDebt Scheme
11Corporate Bond FundAcross DurationHighest rated corporate bonds (min. 80%)
12Credit Risk FundAcross DurationHighest rated corporate bonds (min. 60%)
13Banking and PSU FundAcross DurationDebt Scheme of Banks, PSU Financial Institution
14Gilt FundAcross DurationGovernment Securities (Min 80%)
15Gilt Fund with 10-year constant duration10 yearsGovernment Securities (Min 80%)
16Floater FundAcross DurationFloating Rate Instrument (Min 60%)

It is nice to have so many options as it provides an opportunity to choose the best as per our needs. But, sometimes having so many options simply confuses investors and they are not 100% sure before investing in debt funds. Therefore, there should be a proper way to select a correct debt fund in our portfolio.

Best Way To Choose a Correct Debt Fund

Choosing the best debt fund depends on your investment time horizon & risk capacity i.e. how long you are willing to invest in debt fund. I have tried to list the best types of debt fund to chose based on investment timeframe;

1 to 91 Days

If you want to invest between 1 to 91 days then, the Liquid and Money market funds are the best choice. There are times when you have access cash in your savings account but you might need after a few days or months, then instead of keeping in savings accounts, one can choose to park the money in Liquid or Money market funds.

These funds are investing in government treasury bills, hence are highly safe investment and can generate more than savings account returns.

3 to 6 Months

If you can stretch your investment period more than 3 months but, cannot afford to invest longer than 6 months then, the Ultra Short Term funds could be the best option for you.

These funds usually invest in government treasury bills and commercial papers issued by corporate. Maturity of these investments are also between 3 – 6 months

6 to 12 Months

If you are willing to invest in debt funds between 6 to 12 months then you can go for Low Duration Debt Funds. These funds usually generated more returns than the Ultra Short Term Fund, Liquid, or Money Market Funds.

These funds invest money in Commercial Papers, Commercial Deposits, Corporate Bonds, etc. Commercial Paper and Corporate Bonds are issued by the corporate and Commercial Deposits are issued by the Banks. The maturity of these investments is also less than or equal to 12 months.

1 to 3 Years

One can go for a Short Duration Funds if the investment period is between 1 – 3 years. These funds invest money in Commercial Papers, Commercial Deposits, Corporate Bonds, and debentures. Commercial Paper and Corporate Bonds are issued by the corporate and Commercial Deposit and Debentures are issued by the Financial Institution.

Greater than 3 Years

If you are a long term investor and looking for a debt fund in which you can invest for more than 3 years then you might consider Medium Duration Funds, Medium to Long Duration Fund and Long Duration Funds. These funds have generated returns between 7.5 % to 8.5 Years in the last three years.

These funds are investing money Corporate Bonds, Debentures, and Government Securities. Corporate Bonds are issued by companies, Debentures are issued by financial institutions and Government Securities are issued by the Government. This makes the debt funds more diversified.

Remember, Higher the Investment Horizon higher the returns and higher the risks.

Investment Maturity in which the debt funds are invested is matching with the fund’s maturity. The following chart shows the annualized return from a Short Term Debt fund in three years.

Short Term Debt Fund Return
Chart Credit – Moneycontrol.com

Why Debt Funds Are Better Investment Than Fixed Deposit?

Investors may have different opinions on this because FD is considered as safest investment instrument and it guarantees fixed returns on the investment maturity. Even though the Debt Fund returns are more than FD returns but the returns are not guaranteed and return may fluctuate over the period. But Debt fund offers similar investment security as well as liquidity. Even though the Debt fund returns are higher in the long run, let’s consider the scenario when both the investment instruments generated a similar annual returns.

What if Debt Funds and FD has the same annual returns?

Let’s just say, FD has the same interest rates as of Debt Fund’s annualized return e.g. 7% per annum. Debt Funds get the benefit of indexation that makes it more profitable especially when invested for more than 3 years.

Income tax on the FD returns depends on the income tax slab you fall in, whereas if one can manage to hold the investment for 3 years in debt fund then 20% flat tax will be applicable on returns irrespective of income tax slab. Let’s see a quick comparison between Fixed Deposit and Debt Fund return on INR 1,00,000 investment in 3 years at the rate of 7% annual returns.

debt fund vs fd returns

Debt Funds could be a better choice for you if you fall in 20% or 30% tax slab. You can access this calculation sheet for free here.

Read Also,

I am not saying, FD is not worth investing but one should explore the other opportunities available to get more returns on investment. Fixed Deposits are not paying as they used to pay in past and there are other safe investment options available with similar flexibility and liquidity. However, you should always consult with your financial advisor before putting money into Debt Funds.

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I hope, you found this article useful and it helped you in making informed investment decisions. Do let me know if you have any concerns or need any clarification in the comment section.

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