You are using an older browser version. Please use a supported version for the best MSN experience.

Are debt funds always better than fixed deposits?

LiveMint logoLiveMint 27-06-2017 Lisa Pallavi Barbora

Debt funds are recommended for short- to medium-term allocation, often as a substitute to bank fixed deposits. For such investments, safety of capital and regular income are a greater concern than wealth creation.  A recent blog on the subject (bit.ly/2tWbxnv) questioned the effectiveness of debt funds in outperforming fixed deposits consistently. The blogger analysed annual performance of short-term and ultra short-term funds and 3-year returns for dynamic bond and credit opportunities funds against the State Bank of India’s (SBI) fixed deposit rate for similar tenures. The conclusion was that only few funds delivered better returns than fixed deposits, and that too inconsistently over a period of few years. 

We analysed similar data and found that performance inconsistencies do exist. We considered short-term and ultra short-term funds that were operational from 2008 till 2016, and found that none of them consistently delivered better annual returns than the 1-year fixed deposit, on a pre-tax basis. 

Prajakta Patil/Mint

For data prior to 2014, this is not surprising. Unlike fixed deposits, debt fund returns consist of capital gains (for the growth option). Till July 2014, this was taxed at 10.3% without indexation or 20.6% with indexation, if the fund was held for at least a year. Post-tax returns for debt funds beat fixed deposits given this tax advantage. The interest on fixed deposits is taxed at slab rates, which are between 10.3% and 30.9%. Before 2014, debt funds did not compete with fixed deposits on absolute returns; only post-tax returns mattered. This has since changed. There is no tax advantage for debt funds held till 3 years, after which capital gains are taxed at 20% with indexation. 

Similarly, when we looked at 3-year rolling returns data for dynamic bond funds (better suited for longer tenures) and short-term income funds, the consistency in outperforming fixed deposit return was missing. We did not include income and credit funds as they are meant more for opportunistic investing rather than parking funds. 

According to Surya Bhatia, managing partner, Asset Managers, “Despite being perceived as somewhat passive, short-term income funds are dynamic. We look for funds with excess return of, say, 50-75 basis points (bps) over fixed deposits (based on track record) and consider the tax advantage in staying invested for at least 3 years when choosing funds over deposits.” One bps is one-hundredth of a percentage point.

The data seen in isolation may not make a compelling case for debt funds. However, debt funds are useful thanks to the withdrawal flexibility, and the ability to deliver higher post-tax returns when interest rate cycle is steady or rates are falling. For example, the top five short-term income funds by assets under management have all delivered long-term annualised return of 8-9% (over past 5-10 years). One-year fixed deposit rates from SBI have moved up and down between 9.5% and 6.9%, from 2007 till now.  Barring 2009 and 2010, all these funds outperformed their benchmarks and delivered returns in the range of 7.5-10% each year. For consistent long-term allocation, debt funds can work better. 

First, compare the potential post-tax return based on track record of a fund. Match your investment horizon with the average maturity of the debt fund portfolio. According to Vishal Dhawan, a certified financial planner and founder of Plan Ahead Wealth Advisors Pvt. Ltd, “Often, clients hold money in short-term funds for a few months, assigned to a particular purpose, but it may not get used and continues to remain invested. If it remains for at least 3 years, the post-tax returns are better even if fixed deposit interest rate is similar to the fund return.” 

Second, one has to watch out for debt funds’ expense ratios. At present, short-term income funds are giving an average return of around 9% annualized and expense ratios range from around 1.5% per annum to less than 0.5%. Dhawan said, “Expense ratios make a big difference. It makes sense to re-evaluate allocation from time to time. If you must, then shift out of high-expense funds where others in the category are able to deliver better returns with lower expenses.”

Expense ratios are not fixed. They keep changing for a fund and need to be compared within a category.

Third, interest rate cycles matter to both fixed deposit and short-term fund returns. Fixed deposit rates are increased when the repo rates are rising. But in such a market, debt fund returns can suffer for some time as bond prices fall when interest rates rise. Returns here are made up of interest received from the bonds and securities plus capital gains on bonds if they are sold before maturity. For example, rising rates impacted debt fund returns negatively in 2010 and 2011, whereas the fall in interest rates from 2014 has benefited them. Also, falling rates means lower fixed deposit interest leading to a higher out-performance of funds (see graph).

In periods where interest rates fall, you are better off investing in debt funds, as historically their returns have been superior to those from fixed deposits. When rates are high, fixed deposits could offer higher interest rates. For allocations of less than 3 years, compare fixed deposit rates with the fund’s track record of performance. Look for funds that have managed to deliver consistent returns across interest rate cycles. 

If the period of investment is known and definite, say, 6-12 months (less than 3 years), choosing between a fixed deposit or a fund is only a factor of the returns you can earn. Go with the one that is higher. 

If you are unsure when you might need the money, but need safety and regular income along with returns, also consider the flexibility to redeem. Keep in mind that fixed deposit rates also change. SBI, for example, currently offers 6.9% for 1-year deposits, compared to 8% in 2015. For a 3-year deposit it is even lower at 6.25%. Current average for the short-term funds category is around 9.3% annualised return.

For your regular allocation to debt, which will remain for more than 3 years, debt funds make a better choice thanks to their consistent long-term track record, tax efficiency and flexibility to shift.

Don’t invest in debt funds without doing your homework. Performance track record along with scheme-specific attributes, portfolio credit quality, fund manager track record and expense ratios really do matter.

More From LiveMint

image beaconimage beaconimage beacon