Every income earner is a potential saver and every saver is a potential investor. Statistics suggest that Indian households save more than other developed and emerging economies.

Even in 2008, a year marred by global financial crisis, household savings in India was 25 per cent of the country’s GDP compared with 15 per cent in China and 5 per cent in Brazil; it was one per cent in the US and two per cent in the UK. So, why is the average net worth of Indians so low compared with China or the US or the UK?

When it comes to investments, only 41 per cent of the household savings go into financial assets. Of that 41 per cent, bank deposits account for 18 per cent followed by insurance (12 per cent). This shows that Indians are conservative investors and capital protection is very important for them. However, financial prudence should involve having liquidity for contingencies as well as being a means for capital appreciation.

Perfect blend

For years now, risk-averse investors have considered fixed deposits as the safest bet. But with more mutual fund houses floating pure debt funds, which guarantee a fixed income and assure better returns, conservative investors now have more choices.

If you seek capital appreciation and tax comfort, along with a reasonable safety of capital, debt mutual funds score over bank fixed deposits.

Debt funds are managed by professional money managers who put the money in different bonds and the interest earned on those bonds and debt securities are either distributed to investors in the mutual fund or are reinvested in the fund. Since the bond price varies inversely with the interest rate, inflation and other factors, investments in a debt fund have a fair chance of capital appreciation unlike in a bank fixed deposit.

So, should you take some money out of your fixed deposits and put it in debt funds?

Steady flow

Debt funds invest in fixed-income instruments such as government securities, corporate bonds, certificate of deposit, debentures and so on. The primary objective of debt funds is to obtain a fixed stream of returns in the form of interest, although they offer capital appreciation by marking the portfolio to market value.

The market value of a debt instrument depends on the interest rates on its underlying assets. Also, any upgrade or downgrade in the credit rating of its holdings bears a direct impact on the market price of bonds and the value of the debt fund.

Often the interest income is added to the debt fund and the debt fund’s net asset value (NAV) goes up by this amount. Some variants of debt funds also offer up to 10 per cent equity exposure to clock higher returns.

Debt fund managers make money by riding interest-rate cycles and accordingly shuffling the investment portfolio.

It is generally seen that when market interest rates are benign, debt funds do well. At any given point of time, debt funds tend to give a better return than bank fixed deposits.

Let’s have a look at the performance of debt funds over a one-year, three-year and five-year horizon (see chart).

On an average, debt funds have yielded a return of 9.66 per cent over three years and 11.94 per cent over five years. These returns are higher than a bank fixed deposit over the same time horizon.

Tax gain

Debt mutual funds are also more tax-efficient than bank fixed deposits. This is because the interest income on deposits are added to the investor’s annual income and is taxed at the rate corresponding to the income slab.

Besides, if a depositor’s total interest income from all deposits in a bank branch exceeds Rs 10,000 in a financial year, tax is deducted at the rate of 10.3 per cent.

Since mutual fund dividends are tax-free, the tax efficiency of the investment improves, leading to a higher yield for those in the high-income brackets.

Risk-averse individuals can consider moving some money into debt funds

Besides tax efficiency, a debt fund scores over a bank fixed deposit in capital appreciation. A small equity component in a debt fund provides the edge over a traditional fixed deposit.

For fixed deposits, the interest rate at the time of opening the deposit doesn’t change during the term of the deposit. This means that if the bank revises its deposit rate later, it will not be applicable for existing fixed deposits. This is not the case with bond/debt funds. The bond price will vary with every movement in interest rates and inflation.

When inflation goes up, your bank deposit at a fixed rate earns less for you.

However, in a bond/debt fund, the fund manager can take a call on the inflation movement and sell or buy bonds/debt instruments accordingly and take the benefit of rising interest rates.

Real returns

In the long run, debt funds manage to provide investors a better capital appreciation.

However, an individual’s investment is protected in a fixed deposit. In a volatile market, the value of a debt fund may get eroded, resulting in low or sometimes even negative returns.

Thus, an investor may not receive the expected return on redemption. Risk also arises from the credit rating or quality of the invested instruments.

But, as we have seen before, a fixed deposit doesn’t offer protection against inflation. If the inflation rises steeply during the tenure of a fixed deposit, the inflation-adjusted return could be low or even negative.

For positive returns, the interest rate of a fixed deposit should be much higher than the core inflation rate of the country. Debt mutual funds have managed to generate returns that have surpassed this inflation rate thus providing positive real returns.