Fixed deposit vs debt mutual funds: Which one is better in rising interest rate

Fixed deposit vs debt mutual funds: Amid rising interst rate regime, a good number of Indian banks are offering fixed deposit interest rates to the tune fo 7 per cent or more. In fact, some private lenders are offering FD rates at around 8 per cent as well. So, it becomes a tricky venture for an investor, who is planning for an upfront lumpsum investment in current situation when various central banks across world are highly hawkish.

According to tax and investment experts, debt funds should be preferred ahead of fixed deposits if the time horizon is long or say 3 years or more because debt funds for three years or more is more tax efficient. In current market scenario when interest rates are very high and it is almost at apex, one should go for short term FDs as FD interest rates can come down any time once the central bank changes its hawkish stance on interest rate hike. In fact, debt fund for long term has also become attractive as it give 20 per cent indexation benefit. So, those falling in higher income tax slab can go for debt funds for long term. However, one should note that bank FD is 100 per cent risk-free whereas debt mutual funds attract some risk, though the level of risk is very low.

Highlighting the income tax benefit available in debt mutual funds, Amit Gupta, MD at SAG Infotech said, "Interest through FDs is taxable according to your tax bracket. If you are in the 30 per cent income tax slab, your FD rate of tax will be the same. However, if you invest in debt funds for minimum three years, your effective tax rate reduces since the profits are taxed at 20 per cent. Long-term tax on capital gains on debt funds includes indexation advantages, which decrease taxes even further. As a result, for holding periods of 3 years or more, debt funds provide much higher post-tax returns."

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Amit Gupta of SAG Infotech went on to add that it makes financial sense in debt funds currently, notwithstanding their dismal previous results. However, one should keep in mind that not all debt funds have created equal. Different types of debt funds will react differently.

"Due to the increasing rate scenario, that is nearing its apex, it is better to continue with debt funds having shorter term profiles. If more than a category must be selected, it can be a combination of sleek, poor frequency bond funds and target maturity funds that must be held until maturity," Amit Gupta said.

On what kind of debt funds should be preferred while making an investment decision in rising interest rate regime, CA Manish P Hingar, Founder at Fintoo said, "In the current scenario, if you are planning to invest in Debt space then it is suggested to invest in Target Maturity Funds for a medium to long term Horizon. Target Maturity funds majorly invests in government securities, PSU bonds and high rated papers. They have a tax advantage too as it offers indexation benefit to the investors. Investors who have a very well-defined investment horizon, seeking predictability, and can settle for slightly modest returns, target-maturity funds can add value to their portfolio."

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On how a bank FD account holder can maximise one's return in rising interest rate regime, Fintoo expert said, "Considering the rising interest rates scenario, the impact of such is not seen on fixed deposits with immediate effect but most of the hike in interest rate is already factored in and once the interest rate cycle cools down banks tend to marginalize the rates offered on fixed deposits. Investors can opt for floating rate fixed deposits as their interest rate increases with the rise in interest rates, but investors are advised to not go for very long-term floating fixed deposits as once the elevated interest rates cool down investors can face a downturn in their returns."

However, Manish P Hingar suggested bank depositors to choose floating bank FDs for short term citing, "It is suggested to opt for Floating rate FDs for a period of a maximum of 2 years. An investment tenure longer than this may put an individual at risk of falling interest rate. Therefore, it will make sense to invest in long-term fixed rate FDs when the interest rates are peaked out to lock in the higher rate of interest for the long term."

Disclaimer: The views and recommendations made above are those of individual analysts or personal finance companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.