Why are debt mutual funds better investments than bank FDs

It is very encouraging to note that debt mutual funds are gaining traction with retail investors. As per CRISIL, the debt mutual fund folios as a percentage of total individual investors’ folios increased to 14% in December 2018 from 7% in September 2009. However, average household investment in debt mutual funds is still a very miniscule percentage of household savings. Vast majority of retail investors in India still invest most of their savings in traditional fixed income instruments like Bank FDs and Government Small Savings Schemes. In this blog post, we will discuss why debt mutual funds are much better investment options than FDs.

Risk free versus market linked investments

At the very outset, investors should know that debt mutual funds are market linked instruments and therefore, are not risk-free unlike bank fixed deposits. At the same time, investors should understand that risk and return are directly related. The risk free rate of return is the lowest possible return in the longer term. Investors should take a well informed view on risk and make investment decisions accordingly. By a well informed view on risk, we mean that different types of debt mutual funds have different risk profiles and investors should invest according to their risk appetites. There will be periods of times, when debt funds will give lower returns than bank FDs, but across most periods they are likely to beat FDs as we will see in the next section.

Suggested reading: Debt mutual fund investments – what are the myths versus reality

Average debt fund returns are higher than FDs

Debt mutual funds are subject to interest rate risk and credit risk. Credit risk is security specific, while interest rate risk affects all fixed income securities of similar maturity profiles. So when interest rate changes, all debt funds of similar maturity profiles are affected, either on the upside or downside. FDs on the other hand are not affected by interest rate changes since they assure a certain interest rate. This can work either to the advantage or disadvantage of depositors, depending on interest rate movement. If interest rates go up during the FD tenure then investors lose, but if the interest rate goes down then investors gain. The same applies to debt mutual fund investors, but the magnitude of gain or loss is different compared to FDs and also varies for different types of debt mutual funds.

Which instrument, debt fund or FD, usually gives higher returns, if we combine all interest rate scenarios based on the likelihood of these scenarios? In order to understand this, we use an analytical measure known as rolling returns. Rolling returns measures returns (over a specific investment tenor) across different market conditions, thereby removing the bias associated with interest rates prevailing during a particular point to point period in time. We looked at 3 year rolling returns of different types of debt funds over the last 5 years, which covered various interest rate cycles e.g. rising, falling, flat etc.

Short duration debt funds gave on average 7.7% annualized 3 years rolling returns over the last 5 years and long duration debt funds gave 8.3% annualized returns over the same period. Please note that the debt fund returns mentioned here are category average returns; top performing funds would have given higher average rolling returns. The average FD interest rate over the last 5 years was 6.9%. Both short duration and long duration funds outperformed FDs during this period. Therefore for investment tenors of 3 years, both short and long duration debt funds outperformed FDs.

Source: Advisorkhoj Research

The rolling returns analysis of different types of debt funds show that, across different interest rate scenarios, they are likely to beat FD returns.

You may like to read why long term debt funds are underperforming short term debt funds

Risk / Return trade-off

Debt funds are subject to market risk, while FDs are risk free products. FDs are suitable for investors who do not want to take any risk, but is the risk return trade-off favorable for debt fund investors? In order to get an insight into the risk return trade-off for debt funds, we will look at average 3 year annualized return, highest 3 year annualized return and lowest 3 year annualized return for short duration and long duration funds over the last 5 years for short duration and long duration debt fund categories -

Source: Advisorkhoj Research

In the worst case scenario, short duration funds gave 50 bps less returns than FD but on average gave 80 bps higher returns than FD. In the best case scenario, short duration funds gave 200 bps higher returns than FD. If we take the worst case scenario versus average returns of short duration funds relative to FD, then the risk return trade off is favorable. If we factor the best case scenario risk return trade-off improves further.

In the worst case scenario, long duration funds gave 100 bps less returns than FD but on average gave 140 bps higher returns. In the best case scenario, long duration funds gave nearly 500 bps higher returns than FD. Again the risk return trade-off is favorable if we just compare the worst case scenario versus average returns.

You can also see that long duration funds are considerably more risky than short duration, even though they can potentially give higher returns. You should select debt funds according to your risk appetite. An important assumption in the above analysis is a 3 year investment tenor. Debt funds can be volatile during the tenor of investment; therefore you should be patient and not react in panic. Short duration funds employ accrual strategy. In accrual strategy, price fluctuations have very little impact on the total returns over the investment tenor.

Suggested reading: Should you invest in long term debt mutual funds or avoid

Tax Advantage

Debt mutual funds held for more than 3 years, enjoy considerable tax advantage over bank FDs. Bank FD interest is taxed as per income tax rate of the investors. Capital gains from debt mutual funds held for more than 3 years are taxed at 20%, after allowing for indexation benefits. Indexation benefits reduce the tax obligation for the investors considerably, as shown in the table below.

Conclusion

• Debt mutual funds are market linked instruments. They are subject to interest rate and credit risks.


• Different types of debt mutual funds have different risk profile.


• Over the last 5 years, debt mutual funds on average have outperformed FDs over 3 year investment tenors, across different interest rate scenarios.


• If we compare average debt mutual fund returns across all interest scenarios versus the worst case returns relative to FD assured interest, then the risk / return trade for debt funds is favorable.


• Debt mutual funds enjoy considerable tax advantage over FDs over 3 years plus investment tenors due to long term capital gains tax advantage.

Investors should consult with their financial advisors, if debt mutual funds are suitable for their investments needs.

You must read why you should not ignore debt mutual funds