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This post shows investors in which situations they should invest in FD vs other products like mutual funds.
Table of Contents
- Returns for MF vs FD
- Legal / regulatory
- Unique situations
- Conclusion: Mutual fund vs FD
A common set of questions asked by investors are:
- Should I invest in FD for mutual funds?
- Is FD safe or mutual funds?
The underlying question is that fixed deposits (FD) offer familiarity, safety and known returns under most circumstances while mutual funds do not.
As discussed in our post on choosing investments using the RRTTLLU framework, we will evaluate Fixed Deposits and Mutual funds using the following seven criteria: Return (R), Risk (R), Time horizon (T), Taxes (T), Legal / regulatory (L), Liquidity (L), and Unique situations (U).
Most of the points made here regarding FD apply to recurring deposits as well.
Returns for MF vs FD
At the time of opening, fixed deposits will tell you precisely the maturity value and any interest payments over time. If the FD is held with a bank, the principal is protected and the return is guaranteed.
Mutual funds do not provide any return guarantees. Only overnight and liquid debt funds, depending on their portfolio, offer the some predictability of returns. In addition, mutual funds do not provide any interest. Therefore, investors invest with the expectation that over time, they can sell their mutual fund units at a higher price than their purchase price. There are 30+ categories of mutual funds in India. Historically, some varieties have given higher and the rest lower returns than FD rates over the same period, as shown below.
As the chart shows, there is a lot of variability of returns of FD vs the best and worst mutual funds of that year. This variability is the reason why there is potential for higher returns with mutual funds compared to FDs. Therefore, based on their goal, investors make a conscious choice regarding investing in different types of mutual funds. This topic is covered in detail in this post on asset allocation.
Mutual funds are not the only way to get exposure to the stock, bond, real estate and commodity markets. However, they offer convenience, flexible ticket sizes, and liquidity, making the investment, tracking, and withdrawal easier than alternatives.
If you know exactly how much money you will need and cannot afford the slightest deviation in maturity value, FDs offer a good investment option. However, if the variation is something you can handle, then only you should consider mutual funds.
We will discuss four types of risk:
- Credit risk: whether you get back your principal that you had invested
- Interest rate risk: fluctuations of interest rates in the market keep changing the value of your investments
- Inflation risk: whether your investment is able to meet the future value of your goal
- Reinvestment risk: if you do not need the money immediately and you got a intermediate payout from FD or MF, then you may not get the same return on that payout as the original investment
Consider an existing bond offering a 7% coupon rate versus a new bond with a 6% coupon. The current bond is more desirable, and the NAV of the debt fund holding it will be higher since the 7% bond is more valuable due to the higher coupon. Similarly, the reverse happens, i.e. debt fund NAVs fall if interest rates rise in the economy. The metric for measuring interest rate risk is Modified Duration. It is available for all debt funds (higher the average portfolio maturity,) and measures the portfolio NAV rate of change due to changes in interest rates.
FDs do not have interest rate risk since the rate is known when making the FD.
Due to inflation, the returns from a portfolio has to reach the future target corpus. For example, imagine a goal for a college education for 20 lakhs in 15 years with an inflation of 10%. This goal will be more than 80 lakhs after 15 years (20 * 1.1^15 = 84). So with a starting corpus of 5 lakhs, say, the rest of the target has to come from investments over the next 15 years.
As the FD rates show a decreasing trend, it is unlikely that you can reach the goal via FD investments unless the monthly investments are very high. Mutual funds investing in debt and equity funds over the same period are expected to provide higher returns.
Since banks generally do not offer FDs beyond ten years, you need to reinvest the maturity amount into another FD if the goal is more than ten years away. Similarly, suppose you invest in closed-ended or target-date mutual funds. In that case, once they mature, you need to reinvest the proceeds if the goal is further away. Again, this risk is due to the uncertainty of future interest rates if the goal maturity and the fund/FD maturity do not align. Investing in low duration open-ended mutual funds minimizes this risk since the portfolio reacts adjusts to rate changes. Then, whenever you need the money, you can redeem the units. This article talks more in detail regarding when you should sell mutual funds.
You need to choose an instrument whose maturity ideally aligns with the date you need to spend the money. For example, if the date is within ten years, you can use FD. Alternatively, you can use open-ended mutual funds for any goal duration from days to decades. When the goal horizon is unknown, like when you have parked money for some time (a few months to a few years), you can use either FD or debt MF.
Equity mutual funds should not be used if the horizon is unknown since their returns can be negative over shorter holding periods, as the graph above shows.
FD returns are taxed at the marginal tax of the investor. Therefore, investors would need to pay their taxes due every year in the FD interest, using accrual method, reducing the overall return. Accordingly, investors in the highest tax brackets should re-evaluate investing in FDs beyond a three-year horizon.
At the same time, mutual funds are generally more tax-efficient due to the nature of taxes on capital gains. As per current tax rules, debts funds are taxed on indexed profits beyond three years of holding but taxed in the same way as FDs before three years. This makes debt funds more tax efficient if held for more than three years compared to FD. We have covered capital gains taxes on mutual funds in more detail in this post.
Within three years, FDs offer predictable returns and same taxation as debt mutual funds and hence FD is recommended for investing for that period vs debt MF.
- Saving your sinking fund
- Retiree portfolio cash bucket
Invest the money in SIFI banks: SBI, HDFC, ICICI for maximum safety and liquidity.
Use mutual funds
- For goals beyond three years as per your goal type and asset allocation
- Choose debt mutual funds as per this guide
- Choose equity mutual funds as per this guide