Fixed deposits (FDs) are a popular investment with Indians from all walks of life. Most people have some exposure to FDs, but increasingly, people are also learning about and exploring other investments like different types of mutual funds. Among mutual funds (MFs), debt funds are the most similar to FDs in terms of risk.

A debt fund seeks to provide an investor with stable investment income throughout the period of investment along with capital protection. Investors can choose a debt fund based on their goals and the time horizon of investment.

Comparing debt funds with fixed deposits

In order to understand the differences and similarities between a debt fund and FD, we should have a closer look at each:

Debt fund: Debt funds invest in debt securities such as commercial paper, government securities, etc. depending on the investment objective of the fund. Debt fund returns are linked to the debt markets, yet they provide returns comparable to fixed deposits.

Exit and entry from debt funds is available at all times, unlike fixed deposits. Furthermore, debt funds provide investors with portfolio management where a fund manager takes a call on individual debt securities that constitute a debt fund’s portfolio.

Gains earned on debt funds held for 3 years and above are termed as long term capital gains. These gains are taxed at a lower rate of 20.8% with indexation benefits. Indexation implies increasing the cost of investment in proportion to the inflation rate, which, in turn, lowers taxable capital gains. Short term gains earned on debt funds (held for less than 3 years) are taxed as per your income tax slab.

Fixed Deposits: FDs come with a fixed interest rate which depends on the tenure of your deposit. Fixed deposits are not affected by market highs or lows, but investors should keep in mind that during periods of low-interest rates, debt funds have the tendency to outperform FDs. Fixed deposits are taxed as per your income tax slab and no concessional tax rate applicable to long term capital gains or indexation benefits are available.

Post-tax returns on FDs vs Debt MFs

Let’s compare returns from debt funds and fixed deposits to see how they hold out for a long-term investment.

Type of investment Debt Funds Fixed Deposits
Invested Amount Rs. 2,00,000 Rs. 2,00,000
Investment year FY 2015-2016 FY 2015-2016
Redemption / FD maturity year FY 2018-19 FY 2018-19
Return Rate 7% 7%
Period of Holding 3 Years 3 Years
Investment value at maturity Rs. 2,45,009 Rs. 2,46,288 (quarterly compounding)
Indexed cost of Acquisition Rs. 2,20,472^ NA
Taxable income Rs. 24,536# Rs. 46,288@
Tax rate 20.80% 31.20%
Tax Payable Rs. 5,104* Rs. 14,442*
Post Tax Income Rs. 39,905# Rs. 31,846#
Post Tax Returns (annualized) 6.25% 5.05%

^Based on the cost inflation index table published by the government

# Investment value at maturity minus indexed cost of acquisition

@ Investment value at maturity minus investment amount

*Taxable income x tax rate

# Investment value at maturity minus investment amount minus tax payable

From among the different types of mutual funds, debt funds are suitable for investors looking for steady income with capital protection. Debt funds have the potential to provide superior post-tax returns as compared to fixed deposits. Furthermore, they are likely to significantly outperform FDs in periods of low interest rates.