Fixed Deposit

Is a fixed deposit your only option?

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“So you have spare money in your bank account“, I repeated to confirm what Ajay just told me.

“What are you planning to do with it?“, I further asked.

“Well, It’s about Rs. 5 lacs and I can put them towards my emergency funds. I guess I will create a Fixed Deposit.” Ajay seemed to have made up his mind.

With spare money in your bank account, the most likely thought that comes to your mind is to invest in a fixed deposit.

Read: Liquid Funds – make your cash work harder

But, is the fixed deposit your only option to invest your money?

It seems so. Actually, it is an age old habit from the times when post office and banks were the only places that offered investment options. If it was a long term investment, one put it into a Kisan Vikas Patra, a PPF or a LIC policy and if it was short term, one just opened a FD in a bank or buy Gold.

Those were pretty much the options we could use. And why not? They offered handsome interest rates, in some cases, tax benefits and the feeling of security that your money would be safe.

The world has changed dramatically over decades and so has the world of investing. There are fewer guarantees, interest rates are lower (and inflation higher) and the tax benefits are not that great anymore. (See: Small Savings options)

There are more and better options available to you where you can invest your money today.

So, what are the options?

Now I understand when it comes to investing money you have certain considerations in your mind such as:

  • The money should be safe.
  • There should be an assured return.
  • There should be flexibility to withdraw the money, as and when you want.

And that is why the fixed deposit springs up as a natural option.

But what if I tell you that there is another option that exists which you can use to generate better returns.

In fact, if you are in the highest tax bracket paying 30% of your income as tax and willing to add a dash of risk, this could be your preferred investment option.

And I am referring here to debt mutual funds.

Let’s explore this further.

The world of debt mutual funds

I am sure you are already aware of what mutual funds are. Simply put, they pool money from several investors and then invest in specified equity, debt, gold, real estate, and other opportunities to grow your money or to provide to you regular income. These investments are driven by an investment mandate and a strategy of how and where the money will be invested.

One of the avenues where the mutual funds can invest money is debt. Basically, they invest in bonds of companies who need funds for business as a loan or invest in securities issued by the Government.

Because it is a debt investment, it comes with a predetermined interest rate which the mutual fund earns and then passes on to the investors either through dividends or by way of growth in the value of the investment.

But how are debt mutual funds different than fixed deposits?

Well first, if you see, in case of fixed deposits, the bank agrees to pay you a specific interest over the tenure that you have booked the fixed deposit for. However, if you decide to break the deposit before the due time, you have to pay a penalty, which is usually a loss of interest.

Second, your interest income from fixed deposits is chargeable to tax. As I mentioned, if you are in the 30% tax bracket, you pay 30% tax on your interest. If my friend invests Rs. 5 lacs and receives 8.5% interest, which is Rs. 42,500, the tax payable on the same would be Rs. 12,750. Net of tax he is left with only Rs. 29,750, which as a percentage is just 5.95%.

I am sure you understand that the rate of inflation is much higher than this. Even if you take a 6% inflation rate, Ajay will have to put money from his pocket to get the same value that he got an year ago.

Let us see where do debt mutual funds stand in comparison.

First, the debt mutual funds do not promise a fixed rate of interest that you would earn. The one reason is of course that the regulator does not allow them to so. But only if we were to consider the past, it appears that they have been performing better than the fixed deposits. This is because they invest in credit of highly rated companies.

Second, you can withdraw your money anytime you want from these funds except in cases where there is a predefined lock-in.For example, Fixed Maturity Plans or FMPs come with a lock-in. Some of these funds also charge an exit load if you withdraw before a minimum time frame ranging from a few days to a few months. For example, if you were to withdraw your money in less than a year from Franklin India Income opportunities fund, you would have to pay up an exit load of 3%, 2% if between 1 to 2 years and 1% if between 2 to 3 years.

Third, from a taxation point of view, it is similar to fixed deposits, a tad better I would say. So, if you withdraw your investment within 3 years, than you would have to pay a tax similar to fixed deposits, which is based on your income tax bracket.

However, if you withdraw your investment after 3 years, then you need to pay only capital gains tax. The tax rate on capital gains is much lower at 20%, that too after indexation. Indexation is a method where the cost of purchase of an asset is adjusted for inflation over the years.

For example, if Ajay earned say the same rate of 8.5% compounded over 3 years, his value would be Rs. 638,645. The gains are Rs. 138,645.

If this was a FD he would pay 30% tax, that is, Rs. 41,593.50.

But with a debt mutual fund the capital gains tax would apply @ 20% post indexation. Let’s assume that the indexation factor is constant at 5% per year. So in 3 years the cost will be up to Rs. 578813 (Rs. 5 lac * 1.05 * 1.05 *1.05).

The adjusted gains would be at Rs. 78,813. The tax on these @20% would be just Rs. 15,763.

Adjusted for inflation, Ajay would still be in a greater positive zone.

“Well, that sounds great. But which debt funds should I choose?”

Let me first sound you a word of caution. The debt mutual funds are market linked investments and any untoward movements in the market can have an impact on the value of these funds too.

Some debt funds, in the zeal to provide higher returns, can invest in debt of companies which are not financially strong or mismanaged and this could lead to loss of capital too.

But then you always have some spoilsports in the market. For that matter, even banks have been shut down in the past for not being run efficiently.

This should not deter you from choosing the funds that invest after doing proper diligence and invest in only high or very high rated credit/bonds.

There are 3 types of funds you should look at :

  1. Liquid Funds
  2. Ultra Short Term Funds
  3. Short Term / Income Funds

 

To know more, read a detailed note on this link: Bank FDs or Liquid, Ultra Short funds 

What’s the recommendation?

If safety is super important for you, more than anything else, than you can probably stick with fixed deposits. I would recommend that these funds find a place in your portfolio. In your financial plan, you would need to set aside funds for emergency and other short term needs. A portion of that money can be invested in these debt funds. However, you should consult your financial advisor to guide you on what is most suitable to your needs.

Final statutory warning: Mutual fund investments are subject to market risk. Past performance or returns are no guarantee of future performance. Please read the scheme offer document carefully before investing.

Between you and me: Have you invested in debt funds? How has your experience been? Love to read your views and comments.

22 thoughts on “Is a fixed deposit your only option?”

  1. Hi Vipin

    I found it good , but as a first time investor where I must start from, say if I have 50000 in my account , I can do FD or invest a lumpsum amt in LIC or may be in SIP.
    But I am not sure where to start from , and what if I require this money in emergency.

    • Sonam,
      if you are in the lower tax bracket and may need money in emergency, you may want to just stick with FDs. You may want to stay away from LIC or any investment based insurance policy.
      Thank you

  2. Hi Vipin,

    I was looking at MIP both conservative and agrressive as an alternative to FDs.Is that also a good option?
    I am mid -aged,not looking for monthly income hence wanted to opt for MIP growth,but confused with MIP taxation.MIP are taxed on dividends.If Iopted for MIP Growth without any fixed withdrawl option,will still divident tax apply or will it get treated as Debt fund with longterm and short term Capital Gains tax?

      • Thanks for prompt response Vipin
        My goal is to distribute my Debt portfolio from Bank FDs
        Debt funds are as good as FD but with TAX benefit
        I beleive because of the small equity component ( 0% to 30%)in Aggresive MIPs they can offer a good return in debt portfolio with low risk which makes it better than Balanced Equity Funds and Debt Funds on eiher side of investments
        Hence I believe along with Bank FDs,Debt Mutual Funds a person should also diverisfy and invest in Agrresive MIPs as one of the debt instruments

        What is your thought on this?

        • You could have a different perspective on this.

          What you are essentially doing is using a product with a built in asset allocation instead of creating your own. A product that has predominantly investments in debt with an allocation to equity.

          Now please do not get swayed by past returns. Ultimately, you will get a weighted average return of the two asset classes in the future. So, if equity delivers say a 12% and debt 8%. Then an MIP with 30% equity should give you 9.8% before taxes.

          It is not about being better than Balanced funds or pure debt funds, but the allocation and risk you choose for the goals you have.
          To distribute debt portfolio from Bank FDs is a not a goal. That is an action, as a result of a strategy for achieving a goal.

          Debt funds are not as good as FDs as you would presume. I had invested in an MIP in August 2007 and with a few months, the investment went below its original value. There were periods when the value dropped from the previous one. See this link and scroll down to see the performance chart: https://smart.unovest.co/pages/scheme-details.aspx?schemecode=yNbXmE0zdUg=

          It looks quite similar to an equity fund chart. Doesn’t it?

          I am not trying to desist you from investing, only helping you see the relevant facts.

          Hope this helps.
          All the best!

  3. Hi Vipin,
    I read online that one has to pay Capital gains tax after 3 years on debt funds. This is 20% with indexation. But your article mentions a flat tax of 10%. Can you please explain?
    Thanks.

    • Dear Shilpi

      Thank you so much for pointing this out. You are correct. The long term capital gains tax (post 3 years of holding) is 20% with indexation. Have corrected the same in the article too.

      Regards
      Vipin

  4. Great article Vipin. I am looking forward to invest some cash and just searching satisfying options.
    But are Mutual funds the only other option after traditional investments? I have read about “Peer to peer” lending sites in India which seems very promising and profitable. What are your views on that?

    • Hi Amit, thanks for reading. p2p is an upcoming option. Yet to prove itself in a big way. RBI has taken cognisance of the space and is framing the relevant guidelines.
      You would need to understand pros and cons throughly before going for it. The good part is that you need not commit a lot of money on a p2p platform.
      If you feel like it, go ahead and try out.

  5. Hi Sir,

    Awesome article. Is there an alternative investment method, where I can get monthly returns just like Fixed Deposits. But should not be a fixed interest as it is prohibited in my community.

    Thank you.

    Regards,

    Enayathullah

  6. Dear Sir

    I have a same senario, that i would like to invest my Emergency amount in a Capital Protection oriented funds.. Do you think, it is a good option. what is the diff between Capital protection Fund & Debt Fund.

    • I would like to add 1.5 Lakhs per year in CPOF for next 3 Years so that after 3 years i will get every year returns on my hand for liquidity.
      Kindly suggest me that is it a good option to do.

      I have a hesitation to debt fund that the amount may go negative if markets are not performing good. if its good, then CPOF also will fetch the good returns.

      • Dear Raja,

        CPOF funds use a mix of debt and equity to ensure that you get back at least your invested amount. Well, why would you want to do that? Even a BanK FD would give your principal plus interest.

        With Debt funds, you are taking a little more chance and asking for a return which could be slightly higher than a Bank FD, without the lock in that is there in a Bank FD or a CPOF. So, you will have liquidity available for always.

        Debt fund can go negative, usually, for a very limited period of time and more so when they make stupid investment mistakes. However, you should go for a Liquid Fund or an Ultra short term fund – and not any other income fund, credit opportunities fund, CPOF, etc.

        Hope this helps.
        (smart.unovest.co)

        • Really it helps me a lot. Thanks to you for spending your valid time to response to our queries… Though sometimes our queries sounds stupid 🙁

          And I want to diversify the Emergency fund also like, Some amount is in FD, Swipein Account & Liquid funds.

          • Don’t worry Raja about stupid questions. It is very important to ask questions, however stupid they might seem to be. Better be a laughter stock now.

            Diversifying is a good idea. 🙂

  9. Wow..

    Debt fund explained in a very layman’s language. One of those few articles which has explained debt fund in such an easy way.

    Kudos to you.

    would like to add few points:

    1. Post increment in duration from 1 yr to 3 yr to get indexation benefit has made these debt funds bit unattractive if your holding period is less than 3 years. when it comes to less than 3 years , debt fund face a very tough competition with FD bcz FD gives you zero volatility return where as in debt funds little bit of volatility will be there. Also in some o the fund mentiond by you, there are stiff exit loads for coming out early.

    2. I won’t (whether it is FMP/credit opportunities fund/corporate bond fund) recommend any of these for short term needs that is less than 3 years.

    3. For short term parking (upto 1 year) its better to go for ultra short term funds (a class of fund which is little bit on the upper side as compare to liquid funds in terms of maturity of papers). or even go for arbitrage funds

    4. From 1 yr to less than 3 year, i would go for ARBITRAGE FUNDS (agreeing to the fact that there are some risk but as said by you But then you always have some spoilsports in the market. For that matter, even banks have been shut down in the past for not being run efficiently.)

    For more about arbitrage funds, here is a link:

    http://freefincal.com/can-you-think-of-a-risk-free-and-tax-free-financial-instrument/

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