Why Debt Mutual Funds Matter

Despite the change in taxation, debt funds continue to remain a favourable option than traditional debt instruments like FDs

Mutual funds and fixed deposits have been popular investment options in the Indian financial ecosystem. These choices give people a way to increase their financial security while skilfully controlling risk. To make wise choices, it is necessary to thoroughly analyse the unique characteristics and implications associated with each investment vehicle. With a focus on their merits and demerits in the Indian context, this article seeks to provide an in-depth analysis of how debt mutual fund stacks up against the other traditional options available.

Interest Rate

It is widely assumed that interest rates have peaked out in the current economic situation and is expected to go down in the future. This has serious consequences for an investor looking to make a debt investment. If the interest rates are headed lower, then at the time of reinvestment in case of traditional debt option like the fixed deposit, risk-averse investors are vulnerable to reinvestment risk at low interest rates. Debt Mutual funds, on the other hand, in a falling interest rate scenario has room for capital appreciation allowing investors to make some meaningful gains over and above the interest earned by the portfolio of the scheme.

Penalty for Premature Withdrawal

When comparing two debt investment options, the fee for premature withdrawals must be taken into account. If depositors need to access their money before the investment matures, in case of traditional options, there are fees involved. This penalty has a sizeable impact on total returns. It also restricts liquidity in case of unanticipated financial requirements. Debt Mutual funds, in contrast, provide greater comfort and flexibility as they do not have any exit loads, enabling investors to access their investments as and when needed.

Further, if the need of the fund is after some time of maturity, in case of traditional debt investment option, the interest earned will be very nominal. On the other hand, in case of debt mutual fund, the portfolio would continue to earn the prevailing rate of return for remaining period as well. As a result, the return tends to much better than a short term fixed deposit rate or saving bank rates. Hence, debt mutual funds provide investors the opportunity to optimise returns.

Flexibility

In India, it is important to differentiate between traditional investment options and mutual funds by taking their transferability into account. A debt instrument like fixed deposit is nontransferable in nature. Due to this, investors cannot adapt their financial plans as per their changing conditions. But when it comes to debt mutual fund, the fund units are transferable. An investor has the flexibility to switch funds, alter their investing strategy with the changing time and the nature of fund requirement, thereby providing investors absolute flexibility.

Capital Gain and Taxation

Understanding the treatment of capital gains and taxation becomes important when assessing the potential advantages of traditional debt instruments and mutual funds in India. Here, an instrument like fixed deposit cannot compete with mutual fund in terms of capital gains.

This is because existing debt mutual fund has the potential to witness capital gains as interest rates decrease, which is not possible with fixed deposits. As a result, at this juncture of interest rate cycle, debt mutual fund offers better potential for capital growth, thereby enhancing the overall portfolio returns.

Additionally, both debt mutual fund and traditional investment strategies have very different tax consequences. The interest earned in case of an instrument like the fixed deposit is subject to annual taxation, which reduces the compounding effect of returns. Mutual funds, on the other hand, provide a deferred tax payment structure. Tax on the gains is only considered at the time of redemption, giving investors the opportunity to benefit from compounding and deferred taxation. Given this structure, investors who are trying to maximise their post-tax returns will find debt mutual funds to be better placed.

TDS

In certain situations, fixed deposits are liable to Tax Deducted at Source (TDS). When interest income is above a certain threshold, banks deduct TDS. Such a deduction reduces an investor’s cash flow. On the other hand, mutual funds do not charge TDS, giving investors the benefit of accruing full interest income and maximising investment profits.

To conclude, at a time when interest rate has peaked, to take advantage of potential capital gain when interest rates start coming down, it is advised to invest in debt mutual fund. To pick the most suitable debt scheme as per one’s portfolio and financial goal requirement, it is better to consult a financial advisor.