More appetite for FDs when compared to debt funds: What should you pick?

The advantage of short-term debt funds is that it has higher liquidity and can be withdrawn only when the needs com

Bank Fixed Deposits ( FDs) are emerging to be a stronger product than longer-duration debt mutual fund schemes on the back of interest rate hikes and the removal of tax advantages previously enjoyed by long-duration debt funds, according to a Mutual Funds Report by Motilal Oswal Financial Services. However, the demand for short-duration debt funds remains strong.

“On the debt side, the momentum remains weak as large institutional investors are waiting on the sidelines given the geopolitical tensions across the world. FD is emerging to be a stronger product vs. longer-duration MF schemes. However, demand remains strong for the shorter duration (< 1 year) schemes,” the report said.

But as an investor what should you choose? A short-term debt fund or an FD? 

Currently, banks are offering interest rates between 7-8.50 percent on fixed deposits, whereas some small finance banks are even offering interest rates as high as 9 per cent on FDs while the  10-year bond yield in India has moved up to 7.35% from 7.0% in May 2023. Many are wondering whether locking in their money in the high-interest fixed deposits offered by small finance banks is a smart option.

FD rates being offered by small finance banks ( Data compiled by Paisabazaar) 

sd

But first, we should understand how small finance banks are offering up to 9 per cent interest rates to their investors.

"These banks primarily offer loans to the high-risk category of small businesses, farmers and workers in the unorganised sector. Due to the high risk, these banks are compelled to raise money from the market at a higher rate. Since FDs are one way of raising funds, these banks offer - rather, have to offer - higher interest rates to their depositors..Since SFBs deal with high-risk categories, your FD's risk level will be higher, too. They are more vulnerable to toxic loans (where loans aren't returned) than commercial banks such as SBI, HDFC and its like," said Value Research's Satyajit Sen.

In the worst-case scenario of your FD coming under threat, you have a safety net of Rs 5 lakh only. "Put simply, if an SFB declares bankruptcy, you'll get back only Rs 5 lakh of your deposit in 90 days. The Rs 5 lakh includes both the principal and interest amount," explained Sen. 

But is it a terrible option? 

Not really! 

Fixed deposits offer a consistent interest rate throughout the entire deposit period, ensuring predictability in your end-of-investment returns, except in exceptional circumstances. In contrast, the performance of debt funds is tied to underlying assets, making returns susceptible to fluctuations influenced by factors such as changing interest rates and economic conditions.

Currently, leading banks in India are providing fixed deposit returns exceeding 7%, while debt funds can yield interest rates ranging from 7% to 8%. Debt funds can give you mark-to-market gains if you invest at the peak of the interest rates and rates come down swiftly 

 "It's worth noting that the fixed deposit interest income is presently on the higher side for risk-averse investors. However, it's essential to remember that just 18 months ago, fixed deposits were yielding interest rates of 4% to 5%. Interest rates are subject to change in the future, impacting the comparative returns between these investment options. Fixed deposits might not provide sufficient returns to outpace inflation, which can erode your purchasing power. Debt funds, on the other hand, may provide better protection against inflation compared to fixed deposits because they have the potential to offer higher returns," said Adhil Shetty of Bankbazaar.

If your investment horizon is short, and you belong to a lower tax bracket and don’t want to take any risk, fixed deposits, offering interest rates over 7%, may present a more attractive choice, as per Shetty. On the other hand, debt funds can serve as a valuable addition to a diversified investment portfolio and potentially higher returns.

"Term deposit rates have risen to their highest in the past five years as banks leverage strong credit demand. Thus, a significant arbitrage exists between the nominal interest rate on FDs and the retail inflation, making them attractive for investment. Moreover, small finance banks offer 1-2% additional interest on term deposits to compete with their established peers. Senior citizens in low or zero tax brackets can benefit from this scenario. Suppose a senior citizen in the zero tax bracket invests in a 1001-day FD in Unity Small Finance Bank. She can get a 9% per annum interest rate compared to 5.02% annual retail inflation- marking a post-tax gain of 3.98%. The market expects RBI to start reducing the key interest rates in the next calendar year, and the banking sector will gradually start factoring in. It is an excellent time for retail investors to lock in the FD rates for 3-5 years," said Anshul Gupta, Co-Founder and Chief Investment Officer, Wint Wealth.

But what about inflation? 

Data analysed by FundsIndia shows that even though FD Rates of large banks have increased in the recent past, post-tax returns are still below the fiscal year 2024 inflation expectation of 5.4 per cent. 

"With banks paying around 6.5%-7% on their FDs, most FD investors are left with a very small margin of safety with respect to their real returns. 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," according to Motilal Oswal.

Debt funds typically 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. 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 shows appreciation during this phase.

Liquidity 

FDs allow you to withdraw money but with a penalty. When you need money before the due date, you have to break the entire FD. As a result, you'd earn lower interest rates. That's where liquid or short-duration funds serve you better because you can withdraw your money at any given point.

"The median interest rate of a three-year FD in SFBs is 7.98 per cent. It's 0.5 per cent higher for senior citizens. On the other hand, short-duration debt funds, on average, are likely to yield 7.14 per cent, while a middle-of-the-road liquid fund delivered 6.63 per cent returns. So, if you invested Rs 4 lakh in a small finance bank FD for three years, your post-tax returns would amount to Rs 4.72 lakh after three years. (For senior citizens, it's Rs 4.77 lakh). Similarly, if you invested the same amount in a short-duration debt fund, your post-tax returns would be would be Rs 4.64 lakh. It would be Rs 4.59 lakh for a liquid fund," said Sen.

What should you do?

"In the current environment where the interest rate has plateaued, investing in FDs and short-term debt MF is almost equivalent with pros and cons on both options. FDs have a slight advantage for needs that are defined and in the near future, say 1-2 years. The con here is that TDS comes into play, even for cumulative FDs, hence the investor ends up paying taxes for interest that has not even come into his/her hand," said Chaitali Dutta of  Azuke Personal Finance Advisory.

The advantage of short-term debt funds is that it has higher liquidity and can be withdrawn only when the need comes up.

"For undefined needs, parking money in short-term debt MF is better. With the interest rate expected to start reducing with lower inflation, sometime next year, the NAVs of debt funds would start going up. So if the investor needs the money only after 3-4 years, then funds are a better choice," said Dutta.
 

On the other hand, the advantage of indexation benefit in debt MFs is no longer applicable. So the gains in these funds get added to income and taxes as per the applicable slab. This taxation comes into play when we redeem.

"Long-duration (3+ years) fixed deposits at some small finance banks are fetching close to 8% per annum interest rate. Compared to this, 10-year G-Sec, the primary underlying asset for long-duration debt funds, is yielding 7.3-7.4% annually. After factoring in the expense ratio, the yield on funds would be even lower. Considering that small finance bank FDs are also guaranteed upto Rs 5 lakh it makes more sense for retail investors to invest in them.

Short-duration funds are comparable to interest rates on savings accounts. However, the major underlying asset of these mutual funds is T-Bills, which are currently trading at a 7% per annum coupon rate. Even after deducting the expense ratio, short-duration debt funds provide a clear edge by 200-300 basis points over bank savings accounts," said Anshul Gupta, Co-Founder and Chief Investment Officer, Wint Wealth.

FD rates are presently quite attractive, and the incremental risks of investing in short-term debt funds over FDs is not justified at the moment. For short-term goals, taking on any incremental risk for the sake of a potential 100-150 bps additional return does not make sense as the impact of such return differentials really only becomes meaningful after compounding kicks in, which takes at least 5 years or more. Stick with the safe haven of FDs for your short term goals," advises Mayank Bhatnagar, Chief Operating Officer, FinEdge.