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How best debt mutual funds are perfect alternatives to fixed deposits

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A vast majority of retail investors in India still prefer traditional fixed income schemes like fixed deposits and Public Provident Fund (PPF) when it comes to safe investments. Bank fixed deposits, Post office small savings schemes like National Savings Certificates (NSC), Monthly Income Scheme (MIP), post office time deposits (TD) etc. The primary appeal of the traditional fixed income schemes is the risk free nature of the investments and also the assured returns over the specified period of investment.

However, with interest rates coming down over the last couple of years or so, more and more investors are flocking to invest in debt mutual funds. Best debt mutual funds are not only good investment options in low interest rate regime, they can also perform well in different interest rate environments.

Unfortunately, awareness about debt mutual funds in India is very low due to a number of misconceptions about debt mutual funds among retail investors.

Let us discuss how best debt mutual funds could be perfect alternatives to traditional fixed income investments. But before that, let us check what the common myths are -

  • Debt mutual funds are very risky

  • Debt mutual funds are only for retired people

  • All debt mutual funds are the same

  • Debt mutual funds do not give high returns given the risk; bank FDs are better options

  • Debt mutual funds only give good returns when interest rates are falling

The reality is that none of the above myths are true. There is a large category of debt mutual fund offerings in the market, which can cater to investor’s different risk profiles, their investment tenures and the income or growth needs.

It is not true that, debt mutual funds give good returns only when interest rates are falling. While long term debt mutual funds (e.g. Income Funds, Gilt Funds etc.) give excellent returns in a declining interest rate scenario, investors can lock in great yields by investing in Fixed Maturity Plans (FMPs), when interest rates are high.

In an uncertain interest rate scenario, dynamic bond funds employ a flexible strategy with respect to duration calls, which enable them to generate fairly stable income in the short term and good returns in the long term.

Historical data shows that, best debt mutual funds were able to outperform bank fixed deposits across almost all time-scales. See the top performing debt mutual funds in India

Investors should also have a rational understanding of risks in debt mutual funds. Like equity funds, debt mutual funds also invest in capital market securities, but unlike equity funds, debt mutual funds invest in debt market securities. The risk in debt market is different, both in nature and magnitude, compared to the stock market.

The risk in debt market, as whole is much lower, because interest rates or bond yields do not have the same volatility as stock prices. However, when credit downgrades of specific bonds take place, then a bond price can fall quite a bit, same as stock price (or even more). But such bonds form a very small percentage of the overall portfolio of most debt funds. The risk of debt funds is much lower than equity funds.

To see how the debt mutual funds have given superior return over fixed deposits, check this tool – Debt Fund versus fixed deposits

Further, different types of debt mutual funds have different risk profiles. Following are the examples –

Money market mutual funds like liquid funds and ultra-short term debt funds are very low risk instruments. It is very rare for a liquid fund or ultra-short term debt fund NAV to fall. Best liquid mutual funds; which are usually used to park funds for a few days up to a few months,historically have given higher returns than comparable traditional fixed income investments like savings bank account.

See the return of top performing liquid mutual funds

For investment tenures ranging from 3 months to a year, you can select ultra-short term debt funds as they historically have given better returns not only over savings bank, but also over short term bank fixed deposits.

See the return of top performing ultra-short term debt mutual funds

Short term debt mutual funds are also low risk investments because they usually invest in Government bonds and non-convertible debentures with maturities not exceeding 2 to 3 years. Interest rate risk is low in short duration bonds. Non-convertible debentures (NCDs) are subject to credit risks. NCDs with high credit ratings have low credit risk, while bonds with lower ratings have higher risk. Lower rated NCDs pay higher interest rates and can give higher returns, but if you are uncomfortable with credit risk, you can avoid funds which have higher exposure to lower rated papers. You can look up the credit quality of a short term debt fund in the fund fact-sheet. Top performing short term debt funds have given around 8% returns in the last 1 year, much higher than FDs over the same period.

See the return of top performing short term debt mutual funds

Long term debt funds or income funds are sensitive to interest rate changes and thus one should invest in it only if the investment horizon is at least 3 years or more. In the short term, these funds can be quite volatile, but in the long term, these funds can generate very good returns. Best long term debt mutual funds gave double digit returns in the last three years.

See the return of top performing long term debt mutual funds


Finally, debt mutual funds enjoy a significant tax advantage over traditional fixed income securities, especially in the long term. Interest income in most traditional fixed income schemes are taxed as per the income tax rate of the investor and tax is deducted on the interest earned.

However, dividends paid by debt mutual funds are tax free in the hands of the investor, but the scheme has to pay dividend distribution tax (DDT) at the rate of 28.84% before paying dividends to investors.

Short term (investments held for less than 36 months) capital gains in debt mutual funds are taxed as per the income tax rate of the investor, however long term (investments held for more than 3 years) are taxed at 20% after allowing 0indexation benefits.

Therefore, we can see that best debt mutual funds are perfect alternatives to fixed income investments like fixed deposits etc. not only from the return perspective but also from the perspective of liquidity and tax efficiency.

Please read the Mutual fund taxation for 2018

Mr. Ajay Kumar Jain, M.Sc, Chief Managing Director
Being the Chairman cum Chief Managing Director, he focuses on holistic investment planning and wealth management and tries to make investment planning simpler for retail and HNI investors. Investor education is one of the prime things that Mr. Ajay Jain focuses on as he believes financial education is the foundation of successful investing. With over two decades of experience, Mr. Jain has made a mark in the Indian mutual fund industry due to his compassion and sheer hard work.

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