We get this question a lot. So let's dive right in.
Debt mutual funds are actively managed funds which invest into a variety of instruments such as corporate bonds, non-convertible debentures (NCD), government securities (G-sec), state development loans (SDL), treasury bills (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.
The Indian mutual fund industry offers exposure to a gamut of debt funds that cater to varied risk-return profiles and suit different needs of investors. So while selecting funds, one should consider the investment horizon and the acceptable level of risk in line with the investor’s risk appetite.
For example, 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.
Now let us look at how mutual funds compare vis-à-vis bank fixed deposits.
In the case of a bank deposit, the maturity amount is known at the time of investment. You know exactly how much you are going to get during a particular time frame. This is not the case with a debt mutual fund, the performance for which is linked to market prices which fluctuate according to evolving interest rate scenario.
Mutual funds being actively managed, have the potential to generate higher returns than the interest rates offered by bank deposits. 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. For example, debt mutual funds delivered double digit returns amid the fall in interest rates between 2019 and 2020. This was because the Reserve Bank of India slashed policy rates to support the economy following the adverse impact of the COVID-19 pandemic.
The potential for return is higher in the case of a fund, but not guaranteed.
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.
One should be cognizant of the inherent risks in debt mutual funds such as interest rate risk (or duration risk), credit risk and liquidity risk which can subject the portfolio to significant drawdowns.
Duration risk subjects an investor to risk of drawdowns due to the marked-to-market impact on bond prices due to change in interest rates. This is because bond prices are inversely related to interest rates – as rates rise, bond prices fall and vice-versa.
Credit risk arises due to the probability of an issuer defaulting in paying the principal and/or interest on the funds loaned to him. Investors take on credit risk (invest in lower-rated securities) since it offers higher yield (interest rate) relative to higher (better) rated corporate debt. Investors also face liquidity risk which is risk of having to sell at a loss (or buy at a premium), to entice a counter party to buy (or sell) a security.
Debt funds have been witness meaningful drawdowns owing to default and downgrades of issuers in the past. Hence, it is crucial to invest in line with your risk appetite.
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 and benefit from favourable taxation, you may consider investing into funds belonging to suitable mutual fund categories in line with your goal and risk-appetite.
Compared to bank deposits, mutual funds do offer favorable taxation for holding periods over 3 years.
When it comes to debt mutual fund, there are short-term capital gains (STCG) for a holding period of up to 3 year, and long-term capital gains (LTCG) for periods above 3 years.
Interest from fixed deposits is taxed annually at the marginal tax rate. In the case of shorter holding periods (up to 3 years), the gains from a debt mutual fund are added to an investor’s income and taxed at the marginal rate, just like the bank fixed deposit. However, STCG is taxed on at the marginal tax rate only at exit/redemption. 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.
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.
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Articles authored by Senior Investment Analyst Mohasin Athanikar