"Money is one of the oldest human inventions and one of the most important, there is none that has been perfected so slowly. Money and financial system are still work in progress. They are still evolving. And anything that is still evolving has its share of problems".
The first line of defense for the public's continued support for the FD is they are unwilling to come out of their comfort zone in terms of investment. Furthermore, the public are neither aware of nor willing to accept the other investment products that are both safe and profitable.
In this article, I will walk through over the debt fund which could be used as alternative to FD. I have made deliberate attempt to keep the article short and simple
What is Bond?
Government Bond are issued by state and central government. These bond fall under the category of government securities (G-Sec). Government bond are mostly risk-free as they invest only in government-oriented works and they don't default in paying out interest and principal back to the investor. The returns are relatively low when compared to other bonds.
On the other hand, private companies borrow money from the public by issuing corporate bonds and debentures in order to expand their business and meet their working capital. The bondholder are promised higher fixed rate of interest. Their promised returns are relatively higher in comparison with the returns of the government bonds. Corporate bond have higher risk than government bond.
The bond issuer makes a promise to pay bondholders a fixed sum of money at a future maturity date which is known as Face value. Every bond is issued with a fixed rate of interest per annum, known as Coupon rate of bond.
Lower returns instrument doesn't require in depth analysis as they fall into low risk. The high interest payouts eventually fall into high-risk category. Before investing in a high-risk bond, it's advisable to research the bond thoroughly, learning about its portfolio, interest risk, credit risk, liquid risk and other prominent factors influencing your investment.
Lets take the case of Green initiative bond.
Consider this, on the brighter side, after one year after investing in this bond, there is slump in the market interest rate of the newer bonds, which means the interest rate of a year old "Green Initiative bond" is relatively higher compared to the new bonds out in the market. Green Initiative Bond holder have the opportunity to sell their bond @ higher bond price [Greater than Face value of Rs.500 per unit] as this bond is currently more valuable in the market due to higher interest rate.
The brief overview of bonds may have aided you in understanding the fundamentals and how they function. Lets talk about the Debt MF.
For an investor, the crucial choice lies between investing in a bond directly or in a bond fund through the mutual fund route. When you buy individual bonds directly, you don’t have to pay fees to manage them. However, bond funds offer benefits despite the operational cost. The biggest advantage of bond funds is diversification.
- No Lock-in period, very liquid so one can withdraw money as and when one requires.
- They are significantly less volatile and less risky than Equity funds
- Few debt funds offer better returns than other popular deposit schemes
- They are an excellent tax efficient in case of long-term investments than many fixed deposits due to indexation benefit.
- There is less risk of defaulting as they invest in number of fixed income securities.
- Debt funds carry interest rate risk and can add/reduce your capital based on interest rate movement
- Debt fund carry credit risk when some fund managers buy bonds of small companies that offer higher interest returns but have higher chance of default.
- Some Debt funds have expense ratio of as high as 2.1% which is deducted from your total return
Some of the Debt funds are
· Overnight fund· Liquid fund· Ultra-Short Duration fund· Money market fund· Short Duration fund· Corporate fund· Gilt fund
Coming to the crux part of this article, Gilt Debt MF is termed as the alternate investment vehicle in the place of FD. Gilt funds are debt funds that primarily invest in government securities having holding period of more than 3 years. Roughly, they invest close to 80% of the investment in the government securities. They give higher returns than other debt funds that invest primarily in government securities. On the flip side, this fund has higher chances of interest risk than other debt funds because of its longer holding period. As a general rule, the longer the holding time, the greater the likelihood that funds may be exposed to interest rate risk. Hence, the longer maturity period of the Gilt fund has higher chance of getting exposed to the risk of fluctuating interest rate. On the other hand, other short term debt funds such as Overnight funds, Liquid funds, ultra-short funds, Short Funds have lower interest risk because of their investment in securities having holding period starting from 1 day to 3 years.
As stated above, the MF are extremely tax-efficient in case of longer maturity period when compared with FD.
Deposit Amount |
Rs. 5,00,000 |
Liquidity |
Anytime |
Premature Withdrawal |
No charges |
Partial withdrawal |
Possible |
Tax deducted at source |
No TDS |
Tax Rate |
20% with Indexation |
Interest |
Rs. 3,05,255 |
Tax Amount |
Rs. 61,051 |
Post Tax returns |
Rs. 2,44,204 |
Raja invested in Fixed Deposit having 5-year tenure offering interest of 10% annually. As per the RBI standard, FD interest would be taxed @ 10%. In the budget of 2019, government announced that tax is not applicable for accrued interest that is less than Rs. 40,000 annually. In case of Raja, his interest accrued is Rs.50,000 annually, which is more than the threshold limit, hence, his interest accrued would be taxed @ 10%.
Deposit Amount |
Rs. 5,00,000 |
Liquidity |
Locked for tenure |
Premature Withdrawal |
2% on interest charged |
Partial withdrawal |
Not possible |
Tax deducted at source |
10% on interest |
Tax Rate |
30% |
Interest |
Rs. 3,05,255 |
Tax Amount |
Rs. 91,577 |
Post Tax returns |
Rs. 2,13,678 |
How could the Debt fund outplay the FD over reducing the tax on the returns?
The answer is "Indexation" - powerful tool to save tax for MF which are long-term in nature (more than 3 years). It helps in adjusting the purchase price with the inflation level. Indexation rates are calculated using Cost Inflation Index (CII). Following are the CII chart over the last 20 years.
Here is the formula for calculating indexation:
Indexation = Actual price paid for the investment * (CII for the fund sale year/CII for the fund investment year)
Bottom Line
Certainly, FD is less risky and has less chances of bankruptcy. FD is considered as Lazy-man's investment tool as the investors are unwilling to take risk in the fluctuating market and they feel comfortable investing in less risky instruments. Over the last 20 years, fixed returns from FD are between 6-8%, and unfortunately, this range of return from the FD fails to beat the inflation and paying higher tax on returns. Assume this, the annual inflation is 6% and returns accrued from the FD is 8% annually. It means the inflation has eaten most of your returns and the left over (8%-6% = 2%) is your actual returns.
Try incorporating “Laddering invest mechanism on FD”, in case you are not convinced yet on investing in Debt Funds. To counter the fluctuation market, invest in FD wisely through the process of Laddering mechanism.
- Mutual Funds - R.K. Mohapatra
- 108 question and answers on Mutual Funds and SIP - Yadnya Investments.
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