Debt funds especially short term or ultra short term are far more tax efficient than fixed deposits (FD) for people in tax bracket of 10% or more and are pretty consistent in terms of returns. Let’s understand why should we prefer quality debt funds over fixed deposits, when and how much to invest?

Why do we historically prefer FD?

In my childhood, I never remember my mother talking about debt funds vs. fixed deposits as we did not have many debt mutual funds options and historical performance to rely on. I am sure you would not have heard as well. The challenge is we are wired to open a fixed deposit with any extra cash in our hands or even open deposits worth more than 10 lacs even if we are in a 10% to 30% tax bracket.

It is easy to open one and banks promote it. Banks need fixed deposits to lend part of it to other customers and make money on the margin. Your banker will always promote you to open a fixed deposit while chanting about security. In reality, we should understand how much money we get in our hands post taxes and whether it is enough to beat the inflation.

What are the debt mutual funds?

A debt fund invests its money in corporate or government fixed income instruments such as bonds, treasury bills, etc. It’s similar to an investor giving a loan to a company where debt fund is intermediary. More details can be found here

Why debt funds put more money in pocket?

Firstly, TDS is not deducted in case of debt funds. Tax is deducted only when you sell the mutual fund units and income is realized. This means, your sum can grow at a higher rate than in the case of a Fixed deposit. Check the below table.

Secondly, with inflation of about 5%, you will have to pay tax on reminder of return 8% – 4% i.e. 4%.

Compounding effect

You will see the beauty when you consider 10 years of investment of 10 lacs @8% in short debt fund which earns you 1 lac Rs. more in hand vs. 8% FD investment for the same time. Compared to a short-term debt fund, you would pay more taxes for a fixed deposit and you would get less money in pocket, 6,686 for 10% tax bracket, 48,257 for 20% tax bracket and 89,828 for 30% tax bracket.

See the table below.

Which debt funds to buy and why?

Most experts recommend short term or ultra-short-term debt funds. You should pick the funds which invest in AAA-rated companies or government-backed PSU. I got three such funds for you that I invest in, HDFC short term debt fund, Axis banking and PSU debt fund and Franklin banking and PSU debt fund. I use the Coin app by Zerodha with a direct plan option, more information on the direct option can be found here.

How much to invest in debt funds?

You should keep 6 months of basic living expenses (must-have expenses like rent, electricity, food) in fixed deposits across a couple of banks. Consider moving the remaining money to short term or ultra-short-term debt funds which display little volatility. If you are willing to take more risk, you should go with equity mutual funds or direct equity. For details, refer to this article with key steps of financial planning.

Is there a risk of default by the company?

The three debts funds I mentioned in the article above have a very good history and track record. For banking and PSU debt funds, I do not see any risk since the government guarantees it. For HDFC short term debt funds, the majority of companies are AAA and large-cap such as SBI, Tata sons, LIC, Reliance, Vedanta. I would be willing to bet on these companies paying back principal and interest than invest in fixed deposits and losing money in taxes. Even in case of default by one company, your returns would be negative in single-digit percentages for a year or so and is a rare scenario.

Summary

Remember, debt funds put more money in your pocket in the long run (3 plus years) than fixed deposits until tax law changes. The longer you let the money grow, the more you benefit from debt funds.

Prefer quality debt funds over fixed deposits. Go with direct debt funds to reduce commissions and pick the ones that invest in AAA companies or government securities that still give you reasonable safety compared to other funds.