Are debt mutual funds really an alternative to bank fixed deposits?

In the 12-month period ended January 19, 2020, there are as many as 40 debt funds with negative returns i.e investors have lost money in them so far

Kumar Shankar Roy Jan 20, 2020

Debt FundsIn the last two years, corporate debt defaults and financial sector distress have made it a trial by fire for debt mutual fund investors. IL&FS, Dewan Housing Finance, Essel Group, Cox & Kings, Altico Capital, Sintex-BAPL, Vodafone-Idea are businesses where investments made by debt MFs have sent shivers down the spine of investors. In the 12-month period ended January 19, 2020, there are as many as 40 debt funds with negative returns i.e investors have lost money in them so far! Let that number, 40 debt funds, sink in. The captains of the mutual fund industry can no longer argue that the losses in these debt funds are limited to just a few. In fact, the funds with 1-year negative returns come from as many as 15 separate asset management companies (AMCs).

Rating downgrades, write-downs, NAV losses…such terms are increasingly being associated with debt funds. Enthusiastic fund-house CEOs have prematurely talked about the ‘worst being over’, but it takes only a few months for the unpleasantness to return in debt funds. Nobody knows from where the bad news will trickle in next.

Also read: UTI, Nippon, ABSL MF schemes write down Vodafone Idea exposure after Franklin move

Pitched as a worthy alternative to bank fixed deposits, the debt funds had seen health inflows in the past few years. But investor confidence in debt funds today seems to have shaken in the last one year despite them offering credible tax edge and higher return potential. In this backdrop, investors are right in revisiting an old question: Are debt mutual funds really an alternative to bank fixed deposits? Read on to know the RupeeIQ view.

Debt funds are not ‘fixed income’

These are hard times to defend debt mutual fund investments. The risks of investing in debt funds have clearly come to the fore. But, a lot of misconceptions and misunderstandings about debt MFs is also to blame. Mutual funds are still a new product in India and thus they remain highly under-penetrated. From the initial stage, investor expectations related to debt funds must be set right.

First and foremost, debt funds are not fixed income. The words ‘fixed’ and ‘income’ conjure up a situation where the investor gets a fixed amount at regular intervals like in bank FDs. But, there is nothing fixed about mutual funds. Mutual funds, be it debt or equity, are market-linked instruments. This means there is no ‘fixed’ part. There is no guarantee of anything. All we can refer to is their history. But history is no surety for either the present or the future.

Also read: Have extra cash? Park them in debt funds than in fixed deposits

So, debt mutual funds do not give any surety about protecting your original investment. There is also no guarantee about the higher return. These two things make them entirely different compared to a bank fixed deposit, which gives a “guarantee” (sort of guarantee since the bank liability is fixed at Rs 1 lakh only through an insurance) on your principal and your interest earned.

So all told, if you are somebody who wants 100% protection for your original investment and return, debt mutual funds are not for you.

Also read: Franklin MF debt funds write down Vodafone Idea exposure after SC refuses to review AGR judgement

On the flipside, the lack of guarantee makes debt funds more appealing due to the higher reward possibility (given the higher risk). Guarantees in any financial product have a cost. Bank FDs give you a guarantee, but they also offer lower returns/interest. Annuity products, offered by life insurance companies, give guaranteed income but the returns are lower than even bank deposits.

Know how debt funds generate returns

Any investor who wants to invest in debt mutual funds must understand how the returns will be generated. Sure, debt funds offer higher return potential. But, it is equally important to know where higher returns can come.

Debt mutual funds generate returns from their investors’ money by investing in bonds or deposits of various types. Simply put, debt funds invest your money by lending it and earn interest on the money they have lent. The interest that they earn forms a component of the returns that they generate. Also, debt funds can generate returns by selling debt securities at a higher price than what it cost them. The profit that debt funds clock by selling debt securities at a higher price also forms a component of the returns that they generate for the investors.

Since you now understand how debt funds generate returns for investors, you can also understand when things can go wrong. If the company which has taken a loan from debt funds does not pay interest or principal, it will be a loss for debt funds. Also, if the debt fund sells a debt security at a loss i.e. lower price than at which it bought it, this will also negatively impact returns.

As a debt fund investor, you also need to understand a crucial thing: the NAV and its side-effects. Why side-effects? Every mutual fund, whether debt or equity, needs to reflect the market value of its instruments every day to arrive at its NAV. Thus, the NAV shows what the portfolio of the fund is worth today. When the market value of a debt instrument that a fund holds drops, the fund’s NAV reflects this markdown and thus clocks a sudden 1-day fall. Where the exposure is higher, the NAV fall is higher.

Also read: The difficulties of managing debt funds in India: View by Rajeev Thakkar, CIO, PPFAS Mutual Fund

Tax edge of debt funds

Many people invest money for the prime reason of reducing their annual tax outgo. So, if tax reduction is a crucial investment goal, you can consider investing in debt mutual funds. This is because debt funds are more tax-efficient than traditional investment options like bank fixed deposits

In FDs, the interest you earn on your investments is taxed each year based on the income slab for which you are eligible irrespective of the maturity date being in that year or later. This means if you fall under a high tax slab, your FD income will consequently attract higher tax.

In case of debt funds, you pay tax only in the year you redeem. You pay Short Term Capital Gains (STCG) tax if you hold your debt MF units for less than three years. You pay Long-Term Capital Gains (LTCG) for investments beyond three years. Additionally, LTCG is eligible for indexation benefits wherein you are taxed only on the returns which are over and above the inflation rate, helping reduce your tax outgo as well as providing better post-tax returns.

RupeeIQ take

Bank FDs are like a typical government job in the sense that there is job security even though the salary is less. On the contrary, debt funds are like a private-sector job where the pay is better but the risk of losing your job is much higher.

Investors must remember that debt funds offer higher return potential and better tax benefits compared to bank FDs. But these advantages come without any guarantee or protection for your investment.

Debt funds, over the years, have seen instances where things did not work as per plan. Instead of looking at debt funds and bank FDs as competitors for your money, the smart thing would be to use both in your portfolio. Fixed interest rates over the long-term are trending lower. This means your bank FD, most probably, will earn less interest as years progress. Hence, debt funds are a way to increase overall portfolio returns.

Related:

SEBI brings in enhanced disclosures by rating agencies; is there more short-term stress for debt funds?


Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at kumarsroy@rupeeiq.com.

Subscribe to our newsletter

Envolpe image

Want to grow your money?

Subscribe & keep learning!

 ⓘ Find the best performing mutual funds Explore


Mohammed Haseeb