Where should you invest? Bank Fixed Deposits or Debt Funds?

Investors in bank fixed deposits are on cloud 9 with increased repo rates by the Reserve Bank of India.

FDs Vs Debt Funds

Depositors see increased bank fixed deposit rates. We hear news about banks increasing their bank fixed deposit rates daily. Most private banks now provide their investors with 7% interest rates per annum. You might feel it is better to stick to bank fixed deposits and not with debt funds because of the returns these funds have provided in the last two to three years. However, that might not be such a good idea. Let's see why!

Central banks worldwide, including RBI, have been increasing interest rates to fight inflation. Bond prices and repo rates are inversely related, and bond prices decrease as interest rates rise. The NAV (net asset value) of bond-holding debt funds also reduces. Past returns look meager because of this. However, after a few months of increased interest rates, you see a positive effect. The positive is that the yield-to-maturity (YTM) of such bonds increases. It means that you get higher returns. 

Also ReadBest Indian debt mutual funds.

Debt Funds to Fall Continuously?

It is unlikely that debt funds will see a continuous slump. The YTM has been rising in several debt fund categories. It means that the debt funds that gave poor results in the past will start to give better results. We expect these debt funds to return substantially well. Market-to-market (MTM) has hit the NAVs, and the negative impact will end once the rate hikes slow down or end. It is when the debt funds will start giving better results. MTM movements show the prices of bonds that are impacted by changes in interest rates. It also affects the debt funds. 

Bank Fixed Deposit Rates Might Increase

We expect the bank fixed deposit rates to increase as the RBI increases the interest rates. However, investing in debt funds is a good bet as the YTMs are playing in their favor. Debt funds also have a tax advantage over bank fixed deposits. You must pay tax on fixed deposits according to your income tax slab and would have to pay a higher tax on bank FDs if you are in the higher income tax slab bracket. However, if you invest in debt funds and stay invested for three or more years, you must pay a 20% tax. Indexation benefits also reduce capital gains tax on these funds and offer better returns post-tax. It makes sense to invest in debt funds by looking at these things. 

Also ReadHow do debt funds beat rising interest rates and inflation?

In the current scenario, where interest rates are rising and are almost at their peak, investing in short-term debt funds is the best option. You can even choose target maturity funds, low-duration dynamic bond funds, or ultra-short funds and hold until maturity. Once inflation reduces, you can look to invest in debt funds for the long term. 


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