Debt Fund is a type of mutual fund that invests in fixed income securities like corporate bonds, commercial papers, government securities, and treasury bills, etc. The returns on debt funds depend on the credit ratings of their underlying securities. The better the credit rating the less the returns will be. For example- Bonds issued by the government have no risk of default and thus pay the lowest interest rate relative to other bonds, whereas corporate bonds carry a risk of default and pay higher interest to compensate for this risk.
On the other hand, Fixed Deposits(FD) offer a fixed rate of returns for a fixed time. However, floating-rate fixed deposits are also available, in which interest rate tends to change according to the RBI policies. The FD rates are generally higher for longer durations and lower for a short duration. FDs are also typically considered risk-free (which is not entirely correct-call us to find out why) and therefore offer a low rate of return. One biggest disadvantage of the FDs is that they are for a fixed tenure, and redeeming it before that will attract a huge penalty, varying across banks. Also, in case of premature redemption of FD, the interest rates that are lower between the booked rate and the prevailing rate will be considered.
Types of Debt Funds and Their Comparison with Fixed Deposits
|Fund type||Underlying Securities||Securities Maturity Duration||Yield Range||Comparison with FD|
|Liquid Funds||Money market instruments||Up to 91 days||3.3% to 8%||Their returns are almost equivalent to the FDs, but due to the expense ratio associated with debt fund, FD may seem to be a better option, given that one may not need to withdraw their funds during the tenure.|
|Ultra-short duration fund||Money market instruments and debt securities||Macaulay duration between 3-6 months||3.6% to 9%||(These Debt Mutual Fund) give slightly better returns than FDs. However, at times when the repo rate is too low, FDs can prove to be a better option because bonds are affected by rate cuts instantly whereas FDs may take some time to implement those rate cuts.|
|Short duration funds||Corporate and Government bonds||Macaulay duration of 1 to 3 year||6 to 11%||They generally provide better returns than FD. They do have some credit risk and interest rate risk, but the scope of higher returns is what makes it attractive. Also, higher liquidity gives it an edge over FDs.|
|Medium duration funds||Corporate bonds and other debt securities||Macaulay duration of 3-4 years||8 to 11 %||They are capable of providing better returns than FD. Also, holding a debt fund for more than 3 years will give a tax advantage in the form of indexation benefit, which will result in huge tax savings.|
|Long duration fund||Corporate bonds and other debt securities||Macaulay duration 7-10 years||8 to 12%||They are suitable for investors who want to invest for longer terms as to gain from Indexation benefits and higher returns.|
|Corporate bonds||Minimum 80% of its total assets in corporate bonds having credit rating of AA+ and above||Can be of any duration||7 to 12%||These funds give a better return than FDs with only a minimal amount of risk. They generally don’t have an exit load and therefore can be redeemed anytime without any penalty|
|Credit Risk Fund||Minimum 65% of bonds rated AA and below||Can be of any duration||8 to 13%||These funds are of higher risk than corporate bonds and therefore give better returns. They give much better returns than FD, but with higher risk.|
|Banking and PSU Funds||Minimum 80% in Banking and Public sector||Flexible||7 to 13%||They also provide better returns than FD and they also generally don’t have any exit load which means an investor can redeem it whenever needed.|
|Gilt Fund||Minimum of 80% of total assets in Government Securities||Flexible||6 to 13%||They are very volatile. They can give double-digit returns as well as double-digit negative returns. Preference of the Gilt fund or FD totally depends on the risk appetite of the investor.|
FD is an attractive investment for anyone who doesn’t want any risk. On the other hand, Debt Funds provide many benefits over FDs, like liquidity, indexation benefits, and (higher returns). But we can say that for an investment horizon of more than 3 years, debt fund is definitely a better option because of indexation benefits.
For example- If we invest 10 lakh INR in both FD and a Debt Fund for a simple return of 10% for 5 years. Both will worth 15 lakh 5 years from now. Given a tax bracket of 30%, the income from FD (5 lakh) will result in 3.5 lakh of return after tax. But the case is not the same with the debt fund. Assume inflation is 8% per annum. It means the indexed investment sum will be equal to 14 lakhs and capital gains will just be 1 lakh, which will result in a much higher return after-tax i.e. 4,70,000.