Debt mutual funds or Bank fixed deposits - which is better?

In a recent post, I had briefly mentioned that I prefer bank fixed deposits over debt mutual funds because of the assured returns. Reader Eswar joined issue with me, stating that he preferred debt mutual funds for the convenience of easy liquidity and on-line transactions.

Eswar's point of view made me take a closer look at debt mutual funds to assess the pros and cons vis-a-vis fixed deposits in banks.

Bank fixed deposits (FDs) are amounts kept for specific periods in a bank with a pre-fixed rate of return. The return varies on the time periods, and from bank to bank. Interest payments can be cumulative and paid at the time of maturity, or in monthly or quarterly installments. Many banks calculate the interest accrued on a quarterly basis - hence quarterly interest payment is preferable to monthly payment.

Debt mutual funds (often called income funds) invest more than 50% of their portfolio in corporate debentures, bonds, gilts, treasury bills, bank fixed deposits and commercial papers.  Dividends can be paid out quarterly or monthly (in certain schemes), or reinvested in additional units. The growth option works much like cumulative interest in fixed deposits.

There are four points of departure. Let us look at them one by one:-

1. Interest payments are assured and the principal amount is more secure for a bank FD. There is no assurance of dividend payments or protection of capital for debt mutual funds (MFs).

2. Bank interest is taxable in the hand of the depositor. Dividend payment on debt MFs are tax free in the hand of the depositor, but subject to a dividend distribution tax payment by the MF prior to disbursement of dividend.

3. As on date, bank FDs carry an interest rate of 8-8.25% (with an additional 0.5% interest for senior citizens). Medium term debt MFs have typically given a return of 7-9%. With the security of assured returns and principal protection, investing in bank FD should be a no-brainer at current interest rates. Things change when you calculate the real rate of return after tax.

Those who are in the lower tax brackets may get a slightly better post tax return in a bank FD. But if you are in the highest tax bracket, then debt MFs can provide slightly better post tax returns.

4, If an investor has a sudden requirement for liquidity, a bank FD can be 'broken' (i.e. terminated before the stipulated period) with a penalty of 1% interest. The effective interest will become 7-7.25% at current rates.

For debt MFs, there may be an exit load (of 1%) for redeeming the units prior to 6 months or 1 year from the date of allotment. In case of appreciation in unit NAV (net asset value) at the time of redemption, short term/long term capital gains tax will apply.

So, to answer the question, it depends entirely on the asset allocation plan and risk tolerance of individuals. For older, risk averse investors, bank FDs are still the investment of choice. Younger investors with higher risk tolerance may opt for debt MFs.