Trading and investing are two methods of participating in the stock market, each with its own set of benefits and drawbacks.

For decades, Fixed Deposits (FDs) have been a part of every Indian family. In recent years, however, there has been a decline in FDs, with a notable shift toward debt mutual funds. Let’s look at why debt mutual funds are preferable to fixed deposits in this post.

Shift away from traditional FDs and toward mutual funds

There was a time when all excess money — bonuses and raises – was put in bank FDs. At some point in their lives, our grandparents and parents have all deposited their money in FDs. It was the finest way to make an income while keeping your money safe.

What has changed since then?

Mutual funds have risen to prominence in recent years. As a consequence, FDs are no longer the most popular long-term investment option. During the 2016 demonetization, mutual funds were able to take advantage of the opportunity created by lower deposit return rates. Mutual funds have gained popularity as a result of the availability of tax-advantaged mutual funds. When debt funds began to offer higher yields in exchange for liquidity, many low-risk investors opted to abandon ship.

What Are the Benefits of Investing in Debt Mutual Funds?

In terms of risk, debt funds are the most similar to traditional FDs. The basic purpose of a debt fund is to provide consistent income to investors throughout the course of the investment horizon. As a result, you must choose a time horizon that corresponds to the fund’s. Directly from the fund houses, online, or via a third party, you may learn about numerous debt funds and their durations. This will aid investors in comprehending a fund’s interest rate performance. It will also help you take advantage of market volatility by allowing you to make more educated judgments.

Fixed Deposits vs. Debt Mutual Funds

Consider the distinctions between fixed deposits and debt funds. The table below might assist you in determining which investment is best for you.

  • Particulars
  • Debt Management Funds
  • Fixed-Income Investments
  • Returns on investment
  • 7 percent to 9%
  • 6 percent to 8%
  • Option to get a dividend Yes No
  • Low to Moderate Risk Low to Moderate Risk
  • Liquidity High Low
  • Option for Investing
  • You have the option of making a monthly or one-time investment.
  • Can only make a one-time investment
  • Withdrawal Before the Due Date
  • Depending on the mutual fund type, an exit load may or may not be permitted.
  • Premature withdrawals are subject to a penalty.
  • Investing Expenditure is a term used to describe the amount of money
  • There is a minimal cost ratio charged.
  • There are no management fees.

Fixed deposit interest rates are pre-determined by banks and are dependent on the term specified. The total interest rate change has a big impact on debt fund performance. They may provide modest returns in the form of capital appreciation and regular income (relatively higher than fixed deposits). One advantage of fixed deposits is that market highs and lows have no bearing on the returns you get. Consequently, during periods of low interest rates in the economy, debt funds often outperform fixed deposits by a significant margin.

Debt mutual funds and fixed deposits are subject to taxation.

Short-term profits on debt funds (less than three years) are taxed at your tax slab rate. Long-term gains on debt funds (those held for three years or more) are taxed at 20% with indexation. The profits on fixed deposit returns will be taxed according to your tax bracket.

Debt Mutual Funds and FDs’ Inflation Adaptability

Everyone understands that inflation reduces savings by causing currency value to depreciate. Debt mutual funds offer the ability to keep up with inflation, notwithstanding the risk. For example, if you put in a 6 percent interest savings account and the inflation rate is 5%, your adjusted return will be just 1%. Debt funds may provide better returns than equity funds.

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Using an Illustration to Sum Up

  • Particulars
  • Debt Management Funds
  • Fixed-Income Investments
  • Amount invested (Year of purchase-2015)
  • 2,000,000 Rupees
  • 2,000,000 Rupees
  • The return rate is 7%.
  • 7 percentage points
  • 3 year holding period 3 year holding period
  • At the conclusion of the term, the fund will be valued Rs 2,45,000
  • 2,45,000 rupees
  • Inflation
  • Adjustment is possible.
  • Adjustment is not possible.
  • Acquisition Cost Indexed (Year of sale-2019)
  • 2,20,472 Rupees –
  • Amount Taxed Rs 24,528 Rs 45,000
  • Taxes must be paid (assuming highest tax bracket of 30 percent )
  • 4,906 Rupees (The appropriate tax rate is 20%.) 13,500 Rupees
  • After-tax returns
  • Rs 31,500 Rs 40,094

Finally, consider your risk tolerance, tax bracket, time horizon, and investing objectives before making your pick.

Most Commonly Asked Questions

What are debt funds, exactly?

A debt fund is a mutual fund that invests in fixed-income securities such as government and corporate bonds, Treasury bills, commercial paper, certificates of deposit, and other similar securities. SEBI has divided debt funds into 16 groups after categorising and rationalising them. It divides debt funds into categories based on where the money is invested.

What is the best way to invest in debt funds?

Through the asset management organisation, you may invest in direct debt fund schemes. With the aid of a mutual fund distributor, you might invest in normal debt fund programmes. Consider using an internet platform like cleartax invest to invest in debt funds.

What are short-term debt funds, and how do they work?

Short-term debt funds invest in bonds having a one- to three-year maturity duration. It’s a good fit for low-risk investors who have a similar time horizon. For investors in higher tax bands, it is a more tax-efficient investment than fixed deposits.

What is causing the decline in debt funds?

Debt funds are under pressure to redeem their assets. In India, there is a small secondary market for bonds and money market instruments. As trading volumes decline, selling pressure increases, pushing traded yields higher. Prices decline as a result, and debt funds earn negative returns.

In recent months, the RBI has lowered the repo rate. Short-term debt funds get a lesser return while interest rates are decreasing. Long-term debt funds, on the other hand, do well in a declining interest rate environment.

What are debt funds and how do they work?

Debt funds make money by investing in bonds and other fixed-income instruments. Debt funds would buy these securities and profit from the interest. The interest income determines the returns you and other investors earn from debt funds.

Debt funds invest in various kinds of bonds, the values of which fluctuate with the economy’s interest rates. If a debt mutual fund buys a bond and its price increases owing to a drop in interest rates, the fund will profit in addition to the interest income.

When is it OK to invest in debt funds?

To safeguard your portfolio from the stock market’s volatility, you should diversify it using debt funds. Regardless of your age or how interest rates change in the market, you must always have debt funds in your portfolio.

Debt funds may be appropriate for you depending on your investing goals and risk tolerance. To maximise your return, you should begin investing in debt funds as soon as feasible and remain involved for as long as possible.

What is the best way to invest in debt funds online?

You may invest in debt fund direct plans online by going to the mutual fund house’s website. Fill out the application form and submit your PAN and Aadhaar data to complete your eKYC.

Your information will be verified by the AMC, and you will be able to transfer money using your online bank account. Online platforms such as cleartax invest allow you to invest in direct mutual funds in India.

How do you choose debt funds?

You can select the finest debt funds based on the mutual fund house’s track record. Before investing in debt funds, look at the fund manager’s investment style.

Invest in a mutual fund company that manages a huge amount of money (AUM). During a financial crisis, it may be able to withstand unexpected redemption demand.

Examine the credit quality of the debt fund’s portfolio. You may want to look at debt funds that have AAA-rated bonds in their portfolio.

Depending on your investing horizon, you may want to consider debt funds.

Before investing in debt funds, think about your risk tolerance. Interest rate risk is a concern for debt funds, particularly long-term debt funds.

What are the reasons for bad returns on debt funds?

Interest rate swings have resulted in negative returns for debt funds. Longer-term debt funds are more exposed to interest rate risk.

What are ultra-short debt funds, and how do they work?

Open-ended debt mutual fund schemes are ultra-short debt funds. It invests in bonds having a three- to six-month Macaulay term.

What is the best way to invest in short-term debt funds?

You may invest directly in short-term debt funds via a mutual fund house’s direct programmes. A mutual fund distributor can help you invest in regular short-term debt fund programmes. You may also use an online platform like cleartax invest to invest in short-term debt funds.

The mutual fund house is then chosen from a list of fund houses.

Select short term debt funds from the debt funds category, depending on your investing goals and risk tolerance, and then click Invest today.

You must choose the amount you want to put into the short-term debt fund programme as well as the form of investment, which may be either one-time or monthly SIP.

How can you figure out how much tax you owe on loan funds?

Depending on how long you retain loan funds, you’ll have to pay capital gains tax. Your capital gains are considered short term capital gains if you invest in debt funds for less than three years and then sell your shares (STCG). Short-term capital gains are included in your taxable income and taxed according to your tax rate.

Long term capital gains are earned when you invest in debt funds for three years or longer and then sell your assets (LTCG). Long-term capital gains are taxed at a rate of 20%, plus any relevant cess.

What are accrual debt funds, and how do they work?

An accrual-based method is used by accrual debt funds. It’s a form of debt fund that invests in short- to medium-term debt. It focuses on keeping securities until they reach their maturity date.

In debt funds, what is modified duration?

When interest rates vary, modified duration reveals how sensitive a bond is to price changes. Bond prices and interest rates move in opposing directions, according to a basic notion.

The price sensitivity of a bond to changes in yield to maturity is calculated using modified duration. The modified duration of a bond may be calculated by multiplying the Macaulay Duration by a factor of (1+y/m).

The letters ‘y’ and’m’ stand for the annual yield to maturity and the number of coupon payments each period, respectively.

How do you measure a debt mutual fund’s long-term capital gain?

Long term capital gains are earned when you invest in debt funds for three years or longer and then sell your assets. With the indexation advantage, your long-term capital gains in debt funds are taxed at 20%.

Indexation allows you to alter the cost of debt funds to account for inflation. The Cost of Inflation Index (CII) may be used to index the purchase cost of debt mutual fund units.

For example, if you bought 1,000 units of a debt fund in FY 2013-14 at a NAV of Rs 15, you would have made a Rs 15 profit. In FY 2018-19, you sold 1,000 debt fund units for a NAV of Rs 22. Your earnings of Rs 7,000 (Rs 22- Rs 15) * 1000 are referred to as long term capital gains since you have held the debt fund units for more than three years.

CII for FY 2013-14 is shown as 220. (CII for the purchase year)

CII is listed as 280 for FY 2018-19. (For the year of sale, CII)

ICoA = Original cost of debt fund acquisition* (CII of year of sale/CII of year of purchase), where ICoA is the indexed cost of acquisition.

15000 * (280/220) = 19,091 ICoA

As a result, your capital gains will now be Rs 2,909 instead of Rs 7,000, i.e. (Rs 22,000 – Rs 19,091).

On Rs 2,909, you must pay a 20% long-term capital gains tax, which comes to Rs 582.

Where do debt mutual funds put their money?

Fixed-income securities such as government and corporate bonds, Treasury bills, commercial paper, certificates of deposit, and other money market instruments are invested in by debt mutual funds.

What is the formula for calculating indexation in debt funds?

Indexation allows you to account for inflation in the purchasing price of debt funds. This example will help you learn how to calculate indexation in debt funds.

Assume you put Rs 1 lakh into debt mutual funds in the fiscal year 2015-16. After more than three years, you redeemed your investment for Rs 1,50,000 in FY 2019-20. You have Rs 50,000 in capital gains.

CII is listed as 254 for FY 2015-16. (CII for the purchase year)

For FY 2019-20, you have CII of 289. (For the year of sale, CII)

Inflation Adjusted Purchase Price of Debt Funds = Actual Purchase Price of Debt Funds X (CII in the year of sale/CII in the year of purchase)

= 1,00,000 * (289/254), which is 1,13,780.

After indexation, capital gains are Rs 1,50,000 – Rs 1,13,780 = Rs 36,220.

Instead of Rs 50,000, you must pay 20% LTCG tax on Rs 36,220 (Rs 1,50,000 – Rs 1,00,000).

On your LTCG on debt funds, you pay Rs 7,244 in long-term capital gains tax, which is 20% of Rs 36,220.

What are the many kinds of debt funds?

Debt funds are divided into sixteen categories by SEBI. Overnight funds, liquid funds, ultra-short duration funds, low duration funds, money market funds, short-duration funds, medium-duration funds, medium to long-duration funds, long-duration funds, dynamic funds, corporate bond funds, credit risk funds, banking and PSU funds, gilt funds, gilt funds with 10-year constant duration, and floater funds are some of the options available.

Which debt funds are the best?

Based on your investing goals and risk tolerance, you may choose the optimal debt fund. Take a peek at the debt fund’s portfolio. Debt funds with AAA-rated bonds in the portfolio are an option. When compared to lower-rated bonds, it is safer.

Choose a debt fund with a lower cost ratio than the average. Before choosing the finest debt funds, look at the mutual fund house’s and fund manager’s track records.

In India, how secure are debt mutual funds?

Debt funds invest in fixed-income assets. It is less risky than equity funds, which invest in equities and are vulnerable to stock market volatility. Debt funds may help you diversify your portfolio.

Debt fund safety is determined by the kind of debt fund and interest rate variations. When interest rates rise, long-term debt funds may provide negative returns. When interest rates fall, short-term debt funds give a lesser return. Credit risk funds invest in bonds with a lower credit rating. If the bond issuer fails to make principle and interest payments, you might lose money.

What’s the difference between debt and liquid funds?

Debt funds invest in fixed-income assets and are a form of mutual fund. Debt funds are subdivided into liquid funds. It makes investments in fixed-income securities having maturities of up to 91 days. Other debt funds, on the other hand, may have a longer maturity profile.

Risk: When compared to other debt funds, liquid funds offer the lowest risk. When compared to other debt funds, it has the lowest credit and interest rate risk.

Liquidity: Compared to other debt funds, liquid funds have a high liquidity and can be quickly redeemed at the AMC.

When it comes to mutual funds, what’s the difference between debt and equity?

The major distinction between equity and debt funds is where your money is invested. Equity funds engage primarily in company stock and associated assets, while debt funds invest in fixed-income instruments.

Which is better, equity or debt money, and when should you use them?

Depending on your investing goals and risk tolerance, you may pick between equities and debt funds. To attain your long-term financial objectives, you might invest in equity funds.

Over the long term, say five years, equity funds would do well. Debt funds are appropriate for one- to three-year financial objectives.

What are the differences between equity and debt funds?

The majority of money in equity funds is invested in company stock. Debt funds are mostly invested in fixed-income securities.

Why should you invest in equity and debt funds?

Depending on your investing goals and risk tolerance, you may pick between equities and debt funds. Equity funds would do well in the long run and are appropriate for long-term financial objectives like home ownership or retirement preparation. Debt funds are a secure investment that may be used to save for a trip or other short-term financial objectives.

Why should you invest in debt funds?

To safeguard your portfolio from the stock market’s volatility, you might diversify it using debt funds. To attain short-term financial objectives, you might invest in debt funds. Debt funds are less hazardous than equities funds since they invest in fixed income instruments.

What is the credit risk associated with debt mutual funds?

Debt mutual funds, depending on the kind of debt fund, invest in a portfolio of bonds with varying credit ratings. The likelihood of a bond issuer failing on principal and interest payments is known as credit risk.

Credit risk funds, on the other hand, invest in lower-rated bonds. When compared to debt funds that invest in AAA-rated bonds, it is exposed to credit risk since the risk of default is greater for lower-rated paper.

Why are debt funds preferable to fixed-income investments?

When compared to fixed deposits, debt funds are more tax-efficient. Bank fixed deposit interest is applied to your taxable income and taxed according to your tax rate.

Short-term capital gains are capital gains earned after holding debt funds for less than three years (STCG). The STCG is deducted from your taxable income and taxed according to your tax bracket.

Long-term capital gains, on the other hand, occur when you keep debt funds for three years or longer (LTCG). LTCG is taxed at a rate of 20%, with the advantage of indexation. When compared to bank fixed deposits, it is more tax-efficient.

If you are in a higher tax rate and have a longer investment horizon than three years, debt funds are a better option than bank FDs.

What is a debt fund’s accrual strategy?

Under the accrual method in debt funds, you want to generate a consistent interest income from debt funds and keep the paper until it expires. In fixed income instruments with a short or medium-term maturity, fund managers use the accrual technique. It is primarily a buy-and-hold strategy, in which the portfolio’s securities are kept until maturity.

Accrual funds are debt mutual funds that seek to generate interest income primarily from the coupons supplied by the assets they own. However, capital gains may provide a modest fraction of the overall return for accrual funds.

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