Debt Funds vs Fixed Deposits – Which Investment Option is Better?

Indians have always preferred Fixed Deposits (FDs) because of their simplicity and guaranteed returns. However, the mutual fund industry has also witnessed significant growth in the last few years. According to AMFI, it saw a remarkable surge in Assets Under Management (AUM), growing from Rs 11.81 trillion on January 31, 2015, to Rs 67.25 trillion on January 31, 2025. While this figure covers all types of mutual funds, the growing popularity of debt funds cannot be overlooked. If you are unsure whether to stick with the traditional FD or explore debt funds, this article on debt funds vs FDs can help you make an informed decision.

What are debt funds?

Debt mutual funds invest in bonds and other debt securities like government securities, treasury bills, debentures, commercial papers, and certificates of deposit. These funds are also known as income funds and allocate investments across short-term and long-term securities issued by the government, public financial institutions, and other companies. 

In India, debt funds are categorised into the following 16 types based on their duration and investment strategy:

1. Overnight Fund
2. Liquid Fund
3. Ultra Short Duration Fund
4. Low Duration Fund
5. Money Market Fund
6. Short Duration Fund
7. Medium Duration Fund
8. Medium to Long Duration Fund
9. Long Duration Fund
10. Dynamic Bond Fund
11. Corporate Bond Fund
12. Credit Risk Fund
13. Banking and PSU Fund
14. Gilt Fund
15. Gilt Fund with 10-Year Constant Duration
16. Floater Fund

What are FDs?

FDs are term deposits offered by banks, post offices, and Non-Banking Financial Companies (NBFCs). They come with a fixed tenure and a predetermined interest rate. Upon maturity, the principal amount is returned to you along with the accumulated interest.

Debt funds vs fixed deposits – What are the key differences?

There are many differences between the two:

Risks 

Debt funds are considered low-risk investments, but they are not entirely risk-free. Debt funds do not guarantee capital protection and are subject to risks, including interest rate and credit risk. Fluctuations in interest rates can impact returns, while changes in the credit rating of the underlying securities can affect their performance.

FDs are generally seen as risk-free, but they do carry default risk. If a bank or financial institution becomes insolvent, there is a possibility, even though rare, that you may not recover your investment. However, the risk remains minimal, especially when investing in FDs with reputable institutions. Moreover, deposits up to Rs 5 lakh per depositor per bank are insured.  

Return 

Debt fund returns depend on the performance of the underlying securities. They are not guaranteed and can be influenced by fluctuations in interest rates.

FDs offer guaranteed returns with a predetermined interest rate.

Liquidity

Debt funds generally offer higher liquidity and are designed for quick access to funds. For example, overnight funds invest in securities maturing in just one day, while liquid funds invest in money market instruments with maturities of up to as low as 91 days. However, liquidity can vary depending on the type of debt fund chosen.

FDs can be relatively less liquid, as many banks and financial institutions impose penalties for early withdrawals, which can lower your earnings.

Taxation

The way debt mutual funds are taxed depends on whether you invested in them before or after April 1, 2023.

If you bought debt funds after April 1, 2023, any capital gains will be taxed at your income tax slab rate, just like FDs. You will not get the indexation benefit and can't adjust the purchase price for inflation to lower your taxable gains.

If you invested in debt funds before April 1, 2023, your gains will be taxed as follows:

For FDs, any interest earned is fully taxable. It is added to your total annual income and is taxed according to applicable income tax slabs. Budget 2025 has proposed increasing the Tax Deducted Source (TDS) threshold on FD interest for non-senior citizens from Rs 40,000 to Rs 50,000 per financial year, effective April 1, 2025. Right now, banks deduct TDS at 10% on FD interest if your PAN is available and 20% otherwise.

Is a debt fund better than an FD?

Whether a debt fund is better than an FD is subjective and depends on your financial needs and risk tolerance.  

Debt funds are highly liquid. They may also offer better return potential as they invest in fixed-income securities like government bonds and corporate debt. However, their returns are not guaranteed and can fluctuate based on interest rate movements and credit risks. On the other hand, FDs provide fixed returns and ensure capital safety, which makes them a suitable choice if you prefer capital preservation over growth.

If you have a relatively higher risk appetite, debt funds could be an option, but if your priority is prefixed returns, FDs might be the better choice. In the end, your decision should align with your financial goals, investment horizon, and risk tolerance.

To sum it up   

There is no clear winner in the debt mutual fund vs fixed deposit analysis. Each serves a different purpose and appeals to distinct financial needs. The right choice depends on what you are looking for - stability and guaranteed returns or liquidity and growth potential. Understanding your goals and risk appetite will help you make an informed decision.

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