Exploring Alternatives to Bank FDs: A Deep Dive into Debt Funds

November 23, 2023 Mutual Fund

Fixed Deposits (FD) are a popular financial instrument among Indians, often overshadowing other investment options like bonds, equities, and mutual funds. The deep-rooted preference for FDs stems from their simplicity, attractive interest rates, perceived safety, and the assurance of guaranteed returns at maturity. Nevertheless, considering the fact that FDs are not market-linked, and they might not offer inflation-adjusted returns, investors are ready to explore alternatives beyond fixed deposits.

In response to the evolving investment landscape, individuals are more inclined to strategically take calculated risks aiming for better returns that are also tax efficient. For those exploring alternatives to fixed deposits, there exists a variety of debt mutual funds to consider.

Debt funds have emerged as a viable investment option offering decent returns and flexibility. Among the various categories of debt funds, each serves a distinct purpose and caters to different investment horizons. In this article, we will delve into different debt fund alternatives to bank fixed deposits.

What Are Debt Mutual Funds?

Debt mutual funds are a type of mutual fund that invests primarily in fixed income instruments like corporate bonds, government bonds, certificates of deposits, treasury bills, etc. These funds are designed to offer diversification across debt and money market instruments along with regular income and are expected to be lesser volatile compared to equity funds. As a result, debt mutual funds are well-suited for investors with a low to moderate risk profile and a short to medium-term investment horizon.

The performance of a debt fund is significantly influenced by the prevailing interest rate environment. Additionally, factors such as the credit quality and maturity of the underlying securities within the portfolio can have a severe impact on the fund’s overall returns.

Click here to read about Debt Mutual Funds in detail.

Why Are Debt Mutual Funds a Good Alternative to Fixed Deposits?

Debt funds closely align with fixed deposits in terms of risk. Banks provide a fixed interest rate for fixed deposits based on the chosen duration. The returns from debt funds are largely influenced by the overall movement of interest rates, and they have the potential to generate moderate returns, in the form of both capital appreciation and regular income.

Consequently, debt fund returns are substantially higher than interest on fixed deposits. Since interest rates are nearing their peaks, this could be a good opportunity to invest in debt funds, considering the higher margin of safety at present.

Here Are a Few Things to Keep in Mind When Choosing Debt Funds as an Alternative to Fixed Deposits:

• Debt funds invest their underlying assets into debt securities, whereas fixed deposits represent a type of borrowing undertaken by banks.
• The returns from debt funds can vary based on the movement in interest rates, whereas fixed deposits offer fixed interest rates as determined by the banks.
• Both; debt funds and fixed deposits are taxed according to the individual’s income bracket. Starting from April 01, 2023, the government has eliminated the indexation benefit. Hence, the gains will be taxed according to your income-tax slab, similar to how Short-Term Capital Gains (STCG) on debt mutual funds are taxed.
• Debt funds may be subject to a marginal exit load for short-term withdrawals, whereas fixed deposits attract penalties for premature withdrawals.
• Due to their market-linked nature, debt mutual funds have the potential to deliver returns that surpass inflation, whereas fixed deposits may not be able to generate inflation-beating returns if invested when interest rates are at lower levels.

Here Are Different Types of Debt Funds That Could Be Better Alternatives to Fixed Deposits:

Banking & PSU Debt Fund (2 to 3 years investment horizon):

The Banking & PSU Debt Funds are a type of debt mutual fund that provides investors with an opportunity to secure stable returns through a portfolio of relatively stable, secure, and liquid debt securities. These funds allocate a minimum of 80% of their assets to top-rated corporate debt instruments issued by Banks, Public Sector Undertakings (PSUs), and Public Financial Institutions (PFIs). Instruments from these entities are recognised for their robust credibility and liquidity compared to private issuers, making them a relatively safer investment option.

While there are no strict constraints on portfolio duration, the typical moderate duration of 2 to 3 years in Banking & PSU Debt Funds makes them somewhat sensitive to interest rate fluctuations, especially in uncertain and rising interest rate environments. However, these funds may benefit from regular coupon payments and may adopt a partial accrual strategy to manage volatility during periods of rising interest rates. By investing in high-quality debt instruments with an average maturity of 2 to 3 years, Banking & PSU Debt Funds have the potential to provide stability without exposing the portfolio to undue risks.

For investors seeking a relatively stable option with a moderately low credit risk in the debt mutual fund category, Banking & PSU Debt Funds could be a viable choice. These funds are suitable for individuals with an investment horizon of at least 2 to 3 years and those looking for exposure to highly rated bond instruments issued by Banks, PSUs, and PFIs. It is essential to note that while Banking & PSU Debt Funds can potentially yield higher returns than bank fixed deposits, they do carry a slightly elevated level of credit and interest rate risk.

Dynamic Bond Fund (3 to 5 Years Investment Horizon):

Following SEBI categorisation norms, Dynamic Bond Funds are classified as open-ended dynamic debt schemes with the flexibility to invest across different durations. These funds can allocate its assets to medium to long-term instruments such as corporate bonds and gilt securities as well as short-term instruments like commercial paper and certificates of deposit.

The performance of Dynamic Bond Funds is closely linked to the interest rate environment. In a declining interest rate scenario, long-term instruments tend to excel, whereas in a rising interest rate scenario, short-term instruments tend to outperform. Dynamic Bond Funds adjust their holdings accordingly, anticipating changes in interest rates to create a portfolio diversified across duration. The fund’s success relies heavily on the fund manager’s ability to accurately predict interest rate movements and time investments effectively. If the fund manager misjudges these factors, investors may face losses, and unexpected interest rate movements can lead to short-term volatility.

Considering the inherent volatility, it is advisable to invest in Dynamic Bond Funds only if you can tolerate fluctuations and have a minimum investment horizon of 3-5 years. Despite the associated risks, Dynamic Bond Funds have the potential to yield higher returns compared to short to medium-duration debt mutual funds.

While the impact of interest rate fluctuations may diminish over time, investors should be cautious of funds that carry higher credit risk. In recent years, several funds in this category have increased their exposure to securities issued by government and quasi-government entities due to the rising incidence of defaults and downgrades within the debt fund category.

However, certain funds still maintain a higher allocation to securities issued by private entities, which can offer higher yield but also expose the portfolio to credit risk. Therefore, it is crucial to choose dynamic bond funds cautiously, considering both the potential for returns and the associated credit risk.

Shorter Duration Funds:

For shorter investment horizons, investors have options like Low Duration Funds (up to 1 year), Ultra Short Duration Funds (6 to 12 months), and Liquid Funds (3 to 6 months). These funds provide flexibility and liquidity, making them suitable for short-term goals or parking surplus funds. Nevertheless, investors should scrutinise the portfolio’s quality, considering the credit risk and maturity profiles of the underlying securities.

Low Duration Funds (Investment Horizon of up to 1 Year):

Low Duration Funds allocate their investments to money market instruments and debt securities, ensuring that the Macaulay Duration of the fund falls within the range of 6 to 12 months. These funds are particularly suitable for investors with a one-year investment horizon seeking a low-risk option. While Low Duration Funds have a higher maturity than both liquid funds and overnight funds, they have lower maturity compared to short, medium, and long-duration funds. Investors can utilise these funds to park their money for a duration of 6 to 12 months, earning returns that could surpass those of a savings bank account.

The fund manager of a low-duration fund strategically selects debt securities and money market instruments in alignment with the fund’s investment objective, ensuring that the Macaulay Duration remains within the specified 6 to 12-month range.

Post the SEBI’s new categorisation, investors now have a simplified process for selecting funds based on their financial goals, risk preferences, and investment horizon. Low Duration Funds specifically focus on investing in debt securities and money market instruments with a Macaulay Duration of 6 to 12 months. As a result, investors with a 6 to 12-month investment horizon and a preference for lower risk can find value in these funds. Moreover, Low Duration Funds serve as an attractive option for investing idle funds held in savings bank accounts, offering the potential for better returns.

Ultra Short Term Mutual Funds (6 to 12 Months Investment Horizon):

Ultra Short Term Mutual Funds allocate their investments to debt securities and money market instruments, aiming for a portfolio Macaulay Duration within the range of 3 to 6 months. Hence, these funds are particularly well-suited for conservative investors with a 6 to 12-month investment horizon. They prove to be an excellent choice for individuals aiming to achieve specific financial goals within a 6 to 12-month timeframe.

Furthermore, these funds often yield better returns compared to keeping funds in a savings or fixed deposit account for a similar duration. It is crucial to align your investments with your financial plan and objectives for optimal results.

Liquid Fund (Investment Horizon of 3 to 6 Months):

Liquid Funds are open-ended debt mutual funds that predominantly invest in short-term money market instruments with a maturity of up to 90 days.

These funds allocate their investments to money market instruments such as Certificate of Deposits, Commercial Papers, Term Deposits, Treasury Bills, and similar assets.

Known for their high liquidity and minimal risk, Liquid Funds operate similarly to depositing money in a bank. They invest in short-term debt instruments with a maximum maturity of 13 months, though their average maturity is typically up to 91 days. This short time frame is designed to minimise risk.

Since Liquid Funds are among the least volatile investment options, they are considered suitable for risk-averse investors. However, they too are subject to credit risk as some liquid fund managers tend to carry higher allocation to instruments issued by private entities in pursuit of higher yields.

The impact of changes in interest rates is more significant for papers with longer tenures. Liquid Funds attract investors seeking to temporarily park their funds while prioritising capital safety. If you have short-term financial goals, such as a family vacation, paying off credit card loans, or purchasing a smartphone, Liquid Funds provide a secure option to invest your idle money, yielding returns competitive to your bank savings account.

Are Debt Mutual Funds Entirely Risk-free?

Despite their appeal, it is important to note that debt funds are not entirely risk-free.

Bonds and, consequently, debt funds are exposed to credit risk, given their higher allocation to instruments issued by private entities, driven by their quest for greater yields. Moreover, they exhibit an inverse correlation with interest rates. In periods of rising interest rates, bond prices tend to decline. This is because higher interest rates impact the value of existing bonds.

Duration is a metric that helps you determine the susceptibility of a bond or a debt fund to shifts in interest rates. A higher duration indicates increased sensitivity of a bond or debt fund to changes in interest rates.

Investors must conduct a thorough analysis of the portfolio characteristics, emphasising the quality of papers and investment horizons. Credit risk, interest rate risk, and liquidity risk are inherent in debt funds and can impact returns.

To identify a suitable debt mutual fund, it is crucial to evaluate factors like the sub-categorisation of the fund, the credit quality of the underlying securities, the average maturity and duration profile, the historical performance, the risk ratios, and the investment processes and systems at the fund house.

Regular monitoring and staying informed about economic and market developments are essential for making informed investment decisions.

To conclude:

It is important to note that while debt mutual funds are comparatively stable than equity mutual funds, their returns are not fixed, unlike bank fixed deposits. However, with careful selection of schemes, these funds can provide opportunities for effective diversification and asset allocation, serving as a viable alternative to fixed deposits.

If you are exploring alternatives to Fixed Deposits (FDs), make well-informed choices by evaluating your compatibility with investment goals, risk tolerance, and investment horizon. Debt funds with AAA-rated instruments in the shorter maturity portfolio may be considered as an alternative to low-interest-rate bank fixed deposits.

For risk-averse investors or those approaching retirement who prioritise capital preservation, selecting bank fixed deposits with the highest available interest rate is advisable, and it is crucial to exercise careful consideration in choosing the bank.

Always keep in mind that when investing in debt funds, your primary objective should be capital preservation, with returns being of secondary consideration.

It is imperative for investors to conduct due diligence, assess the risk factors, and align their investment horizon and risk tolerance with the chosen debt fund. In the dynamic landscape of financial markets, informed decision-making is key to optimising returns and effectively managing risk.

This article first appeared on PersonalFN here