Fixed deposits or debt mutual funds? Where to invest when interest rates rise

Fixed deposit investors are a pampered lot these days. With the Reserve Bank of India having hiked repo rates a number of times in recent months, banks too have been increasing FD rates for depositors. Every day, there is news of some bank or the other increasing FD rates. Many large private banks now offer about 7 percent on one-year FDs.

If we compare this with the average debt fund returns of various categories over the past 1-2 years, it’s natural for many savers to feel they should just stick to good old bank FDs. But it is not the correct approach. I will explain why.

The RBI has been hiking interest rates to tame inflation. When policy interest (repo) rates rise, bond prices fall because they are inversely related. As a result, the net asset values (NAV) of debt funds holding bonds also fall. As NAV falls, past returns naturally start looking poor as of today.

However, there is a positive effect as well when interest rates are increased – not immediately, but over the next few months/quarters. And the positive here is that the YTM (yield-to-maturity) of these bonds starts rising. This means that potential returns start going up.

Will debt funds continue to be in a slump?

That’s unlikely.

At present, yields (YTM) have been increasing across debt fund categories. What this means is that even though debt fund returns have been low in the past couple of years, things are expected to turn around quite soon and debt fund returns will increase substantially.

While NAVs have taken a hit due to the mark-to-market (MTM) impact, once the rate hike cycle slows down and ends, the negative MTM impact will be over and debt fund returns will start improving. To be sure, MTM movement denotes the prices of listed bonds that get directly impacted with interest rate movements, which in turn impact your debt funds as well.

Fixed deposit rates might go up, but…

But what about FD rates? Will they increase further?

Possibly, yes. Banks have been dragging their feet in passing on the rate hike to depositors. So, if the RBI further increases policy rates, albeit slowly, FD rates will rise a bit higher.

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But given the scenario of increasing YTMs playing out for debt funds, it may be a good idea to start investing in debt funds now. This is all the more important because of the tax advantage that debt funds have over fixed deposits.

Interest income from FDs is taxed as per your slab. If you belong to the 30 percent bracket, then that is what your FD tax rate will be. But if you remain invested in debt funds for at least three or more years, the effective tax rate falls as the gains are taxed at 20 percent.

Long-term capital gains tax on debt funds comes with indexation benefits, which further reduce taxes. Hence, for holding periods of more than three years, debt funds offer much better post-tax returns.

While it makes a lot of sense to invest in debt funds now, despite their poor past returns, do note that all debt funds are not the same. Different debt fund categories will behave differently.

Given the rising rate scenario, which is close to a peak, it’s best to stick with debt funds with comparatively shorter duration profiles. Or, if more than one category has to be chosen, it can be from a mix of ultra-short, low-duration dynamic bond funds and even target maturity funds, which need to be held till maturity.

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The time to add longer-duration funds is not now but will come when the interest rate cycle is about to turn around and rate cuts are expected once inflation cools down.