Why are debt mutual funds considered better than bank fixed deposits to park money for short periods? And between them (tenure of one month to a year or two), how must I make a selection?
Debt mutual funds are actively managed funds which invest into a variety of instruments such as a corporate bond, non-convertible debenture (NCD), government security (G-sec), state development loan (SDL), treasury bill ((T-bill), commercial paper (CP) and certificate of deposit (CD).
The yield-to-maturity on these funds depends on the yield of the underlying securities which in turn is a function of the maturity (duration) and credit quality of these securities. Funds investing into higher duration and/or lower-rated securities, subject an investor to interest rate risk and/or credit risk. Investors in such securities earn a premium compared to low interest rate risk and safer instruments, to compensate them for the maturity and credit risk that they are being subject to apart from any potential liquidity risk.
The options
Mutual funds offer a gamut of funds with varied risk-return profiles, to suit different needs of investors. While selecting funds, one should consider the investment horizon and the acceptable level of risk in line with the investor’s risk appetite.
For very short tenors, say up to 3-6 months, one can consider investing into liquid or ultra-short term funds which have very low interest and credit risk involved. For relatively longer tenors, one can decide to invest into shorter-term categories (such as low-duration, short duration, banking & PSU) to longer duration categories (such as long-duration funds and 10-year constant maturity gilt funds) with some amount of interest rate and/or credit risk depending on risk appetite.
Do read How to choose a debt fund.
The risk-return dynamic
If you want surety of returns with no risk, you may consider investing in bank fixed deposits. If you wish to benefit from potentially higher gains at the cost of relatively higher risk, you may consider investing into funds belonging to suitable mutual fund categories in line with your goal and risk-appetite.
Yields on various debt fund categories are broadly similar to the interest rates offered on bank deposit for comparable tenors. However, compared to a bank deposit which is a low-risk product offering fixed returns, mutual funds are actively managed with the potential to generate higher returns than the indicative yields. The fund manager can actively increase the duration and/or take credit risk depending on his view of the macroeconomic situation and can position his fund to benefit from his expectations playing out – either through interest rate changes or change in credit spreads.
However, one should be cognizant of the inherent risks in debt mutual funds such as interest rate risk, credit risk and liquidity risk which can subject the portfolio to significant drawdowns as witnessed in recent times.
Banks deposits are fixed-return products with no interest rate and credit risk, and the return is guaranteed at the time of investment. On the contrary, mutual funds are marked-to-market products and are hence impacted by changes in interest rates and credit spreads. For example, the sharp fall in interest rates particularly in short-term rates following various measures by the central bank to mitigate the slowdown in the economy, helped most debt mutual funds deliver double-digit returns in each of the past 2 calendar years.
Exit load
Most of the shorter-duration mutual funds do not levy any exit load/penalty on withdrawal, unlike bank deposits which levy a penalty on early withdrawal.
Tax
From a taxation perspective, interest from fixed deposits is taxed annually at the marginal tax rate.
When it comes to debt mutual fund, there are short-term capital gains (STCG) for a holding period of up to 36 months, and long-term capital gains (LTCG) for periods above 3 years.
STCG is taxed at the marginal tax rate only at exit. This deferred taxation in case of mutual funds results in a higher amount of corpus remaining invested and accruing interest relative to bank fixed deposits. LTCG is taxed at 20% post indexation of cost compared to at the marginal rate in case of bank fixed deposits.
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