Personal Finance

Why debt mutual funds can’t be compared to bank FDs

Aarati Krishnan | Updated on May 10, 2020 Published on May 10, 2020

Fixed deposits guarantee capital, interest; debt funds show high variability in returns

Distress calls from investors after the Franklin Templeton crisis show that many folks who signed up for debt funds seemed to have been lured by their tax-efficiency compared with bank fixed deposits.

Before getting to the tax-efficiency, it is important to recognise that debt funds are fundamentally different from bank FDs. Here’s why comparing the two is like comparing apples to grapefruits.

No capital safety

The fundamental premise of a bank FD is the promise to keep your principal intact.

But daily fluctuations in the value of your investment and the live possibility of capital losses are in-built features of debt funds.

The extent of capital losses you can make depends on the category of debt fund you choose. Credit-risk funds, long-duration funds and gilt funds are the most prone to losses. Credit risk funds can make losses when the bonds they hold default on their dues or face rating downgrades. Long-duration and gilt funds can make losses if market interest rates rise after you invest in them.

The worst-performing credit-risk funds have lost anywhere between 20 per cent and 70 per cent of their NAVs in the last one year, owing to write-offs from corporate bonds that had got downgraded. Gilt funds have made capital losses amounting to 12-13 per cent of their NAVs in a single quarter in January-March 2009 and May-August 2013 when interest rates unexpectedly spiked.

While the above categories are particularly prone to losses, others are not immune. If ultra-short, short, liquid, money market or low duration funds invest in commercial paper/corporate bonds, they can see NAV losses from downgrades or defaults.

Medium-term and dynamic bond funds can make losses if their credit/interest rate bets go awry.

There’s no category of debt funds that’s completely immune to capital losses, though some categories (overnight, liquid) are less vulnerable than others.

No fixed returns

Unlike bank FDs, debt funds show a high variability in their returns on account of their portfolios being marked to market. Your returns from a debt fund come not only from the interest it receives, but also from daily movements in the prices of bonds it owns. Bond prices, like stock prices, swing daily to changes in macro variables, inflation, inflows/outflows and the fundamentals of issuers.

Some categories of debt funds have fewer variations in returns, while some experience a lot of it. Categories such as gilt funds, dynamic bonds, long-duration funds and credit-risk funds are most likely to subject you to a roller coaster on returns, while liquid and overnight funds offer a smoother journey. For instance, gilt funds in the past decade, saw their annual returns swing from minus 7 per cent to a positive 22 per cent, credit-risk funds from zero to 11 per cent, corporate bond funds from 5.5 to 11 per cent and banking/PSU funds from 5.9 to 10 per cent. Short-duration funds have seen their returns fluctuate between sub-5 per cent and 11 per cent in the last 10 years, while liquid fund returns have swung between 5 per cent and 10 per cent.

When investing in debt funds, therefore, don’t expect regular returns like clockwork.

Pass-through structure

Indian regulations treat bank FDs as instruments that carry an implicit capital and interest-rate guarantee.

There are three sets of safety nets in place to ensure that banks honour their deposit obligations even in a crunch situation. One, every bank is required to park 18 per cent of its net demand and time liabilities (its savings and term deposits) in approved government securities, as part of its SLR (Statutory Liquidity Ratio) requirement.

Another 3 per cent is to be held in cash with the Reserve Bank of India (RBI) as the CRR (Cash Reserve Ratio).

Two, under Basel III norms, RBI also requires banks to maintain a minimum Liquidity Cover Ratio (LCR) where the high-quality liquid assets in its balance sheet must cover its projected cash outflows for the next 30 days.

These ratios are apart from capital adequacy norms that insist on banks putting in a minimum amount of their own equity capital for every rupee of lending they do.

Three, all scheduled banks pay a deposit insurance premium to the DICGC (Deposit Insurance and Credit Guarantee Corporation) to fund an insurance cover of up to ₹5 lakh per account holder.

In the event of the bank’s liquidation, all depositors will receive this minimum sum.

In contrast, regulations clearly treat mutual funds as pass-through vehicles. SEBI regulations for debt funds don’t insist on any minimum cash or reserve requirements, but on diversified portfolios, transparent valuation and frequent disclosures of their bond holdings.

This is because the basic purpose of a mutual fund is to ‘pass through’ all losses or profits to its investors after charging its fees. The disclaimer that “mutual funds are subject to market risks” is intended to warn investors that they will be bearing all the gains or losses from the fund manager’s bets, with no safety net.

When you place a withdrawal request for deposits with your bank, it is obliged to manage the liquidity to repay your capital in full. With a mutual fund, it is only obliged to pay you whatever it realises from liquidating its portfolio at prevailing prices.

Finally, yes, debt funds score over bank FDs on taxation. When you hold debt funds beyond 36 months, the gains are liable to long-term capital gains tax at 20 per cent, with indexation benefits. Returns on bank FDs are always taxed at your slab rate.

But if you are not comfortable with capital losses, return volatility or the pass-through structure, you would be better off avoiding debt funds, irrespective of the tax efficiency.

Published on May 10, 2020

A letter from the Editor


Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!

Support Quality Journalism
  1. Comments will be moderated by The Hindu Business Line editorial team.
  2. Comments that are abusive, personal, incendiary or irrelevant cannot be published.
  3. Please write complete sentences. Do not type comments in all capital letters, or in all lower case letters, or using abbreviated text. (example: u cannot substitute for you, d is not 'the', n is not 'and').
  4. We may remove hyperlinks within comments.
  5. Please use a genuine email ID and provide your name, to avoid rejection.
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.