If you ask someone whether Fixed Deposits are better or Debt funds are better, more likely than not, you will hear a biased answer towards either of them. Some swear by FDs and their safety, while others say debt funds always give better returns than FDs. Lets bust some myths and try to get an understanding of how these two types of investments work.


Before going any further, if you are eligible for Senior Citizen Saving Scheme (SCSS), then I would say that is the best fixed asset option for you, if your investment is less than Rs. 15 lakhs. SCSS out of the way, now we are ready to butt FDs against Debt funds. Since there are various characteristics of fixed assets (risk, returns, liquidity, taxation etc), we will go over each of them and compare Debt vs FD. Finally, we will take some examples and compare them to see which fits you better.


Risk

When it comes to safety of your investment, Fixed Deposits win over Debt funds hands down. Even the very safe Liquid Debt Funds are not as safe as Fixed Deposits. There are a couple of risks that affect Debt Funds. One is the interest rate risk and the other is default risk. In the case of Fixed Deposits, you are always sure of the exact rate of return. But in the case of Debt Funds, a change in interest rates will affect your return. When interest rates go up, Debt funds lose out on the returns and vice-versa. The interest rate risk is least in liquid funds, and the highest in long term debt funds. Consequently, long term debt funds have better return compared to liquid funds.


The other kind of risk that affects Debt funds is default risk, because the borrower of a loan can default on the payments or go bankrupt. This happened recently with an NBFC which was rated at investment grade and later dropped to junk rating in a short duration (read about the ILFS crisis). Banks rarely default (there are some cases of co-operative banks defaulting), so you Fixed Deposits are safe. If safety of your investment is of utmost importance to you, then keep your investments in Fixed Deposits.


Returns

Debt funds returns are generally better than Fixed Deposits. Ultra-short term funds have a nice balance of minimal interest rate risk with the upside of slightly better returns than Fixed Deposits. Note that the low interest rate risk Debt Funds (such as ultra-short term funds) don't give much better returns than FDs. But they have their benefits (as you will note below). So, while deciding between Debt Funds and FDs, returns should not be too high in the list.


Liquidity

One of the benefits of Debt Funds is that they are very liquid without affecting your returns. In the case of FDs, you have to pay a penalty if you redeem before the maturity date. While some longer term Debt Funds have an exit load if redeemed with in a year, most ultra short term funds don't. So, if you are not sure if you might need the money unexpectedly, prefer Debt Funds. Generally longer term FDs offer better returns, but you have to be sure that you will not need the money in the interim.


Taxation

Here comes another big difference between Debt funds and FDs other than the safety. FDs are not as tax efficient as Debt Funds in the long term. If you hold Debt Funds for more than 3 years, you are taxed at 20% after indexation. Where as FDs are taxed at your marginal rate no matter how long or short you hold it. The reason is that the interest you earn from FDs are added to your income every year, even if the FD period is more than a year. So whether you take a 5 year FD or 6 month FD, you are taxed at your marginal rate on the interest that you earned in that year. Whereas for Debt Funds, you are only taxed on redemption. So, if you have no income or your tax rate is very low like 5%, then FD may be a better option for you given that you have safety and returns almost like Debt Funds, but only if you don't need the liquidity. While you are better off with Debt Funds if you don't need the money for more than 3 years and can handle the small volatility that comes with them.


Examples

Lets take a couple of examples to see how one could benefit from one over the other. Assume a 7.5% return on FD and 8.0% return on Debt Funds and you want to invest Rs. 10 lakhs.


Example 1

Your income from other sources is Rs. 1.7 lakhs per year and you fall into 5% tax slab once your income exceeds Rs. 2.5 lakhs. You don't need the money for 5 years. You invested from 2013 to 2018.


FD Returns

Year 1
Interest = 7.5% * Rs. 10,00,000 = Rs. 75,000
Total Income = Rs. 1,70,000 + Rs. 75,000 = Rs. 2,45,000
Tax = 0

Year 2
Interest = 7.5% * Rs. 10,75,000 = Rs. 80,625
Total Income = Rs. 1,70,000 + Rs. 80,625 = Rs. 2,50,625
Tax = 5% of 625 = Rs. 31

Year 3
Interest = 7.5% * Rs. 11,55,625 = Rs. 86,671
Total Income = Rs. 1,70,000 + Rs. 86,671 = Rs. 2,56,671
Tax = 5% of 6,671 = Rs. 333

Year 4
Interest = 7.5% * Rs. 12,42,296 = Rs. 93,172
Total Income = Rs. 1,70,000 + Rs. 93,172 = Rs. 2,63,172
Tax = 5% of 13,172 = Rs. 658

Year 5
Interest = 7.5% * Rs. 13,35,468 = Rs. 1,00,160
Total Income = Rs. 1,70,000 + Rs. 1,00,160 = Rs. 2,70,160
Tax = 5% of 20,160 = Rs. 1008

Total value after 5 years is Rs. 14,35,628 (FD maturity value) - Rs. 2,030 (total tax paid) = Rs. 14,33,598


Debt Fund Returns

Value after 5 years = Rs. 14,69,328
Cost inflation index for 2013-14 = 220
Cost inflation index for 2018-19 = 280
Inflation indexed cost = 280 / 220 * Rs. 10,00,000 = Rs. 12,72,727
Capital gain = Rs. 14,69,328 - Rs. 12,72,727 = Rs. 1,96,600
Total Income = Rs. 1,70,000 + Rs. 1,96,600 = Rs. 3,66,600
Tax paid in 5th year = Rs. 1,16,600 * 20% = Rs. 23,320
Total value = Rs. 14,69,328 - Rs. 23,320 = Rs. 14,46,008

You made almost the same amount with Debt funds as with FDs. But in this case you may prefer FDs since they are safer.


Example 2

Your income falls into the highest tax bracket of 30%. You don't need the money for 5 years. You invested from 2013 to 2018.


FD Returns

Year 1
Interest = 7.5% * Rs. 10,00,000 = Rs. 75,000
Tax = 30% of Rs. 75,000 = Rs. 22,500

Year 2
Interest = 7.5% * Rs. 10,75,000 = Rs. 80,625
Tax = 30% of Rs. 80,625 = Rs. 24,187

Year 3
Interest = 7.5% * Rs. 11,55,625 = Rs. 86,671
Tax = 30% of Rs. 86,671 = Rs. 26,001

Year 4
Interest = 7.5% * Rs. 12,42,296 = Rs. 93,172
Tax = 30% of Rs. 93,172 = Rs. 27,951

Year 5
Interest = 7.5% * Rs. 13,35,468 = Rs. 1,00,160
Tax = 30% of Rs. 1,00,160 = Rs. 30,048

Total value after 5 years is Rs. 14,35,628 (FD maturity value) - Rs. 1,30,687 (total tax paid) = Rs. 13,04,941


Debt Fund Returns

Value after 5 years = Rs. 14,69,328
Cost inflation index for 2013-14 = 220
Cost inflation index for 2018-19 = 280
Inflation indexed cost = 280 / 220 * Rs. 10,00,000 = Rs. 12,72,727
Capital gain = Rs. 14,69,328 - Rs. 12,72,727 = Rs. 1,96,600
Tax paid in 5th year = Rs. 1,96,600 * 20% = Rs. 39,320
Total value = Rs. 14,69,328 - Rs. 39,320 = Rs. 14,30,008


In this case you would have made Rs. 1.25 lakhs more than FD. Probably the additional risk is worth it?


Hope this helps you decide which way to go. Sometimes Debt Funds are better and at other times FD is better. You need to take a call on a case by case basis.