Debt Funds vs Fixed Deposits – Where to Park Your Money Post-RBI Rate Cut?

The Reserve Bank of India (RBI), in its monetary policy meeting held from February 5 to February 7, 2025, announced a reduction in the policy repo rate from 6.50% to 6.25%. This marks the first change in the rate after remaining unchanged for eleven consecutive meetings spanning nearly five years. The decision, led by the new RBI Governor, Sanjay Malhotra, involves a 25-basis-point cut.

The repo rate is the interest rate at which the RBI lends to commercial banks, influencing borrowing costs for businesses and individuals. A lower repo rate is expected to prompt banks to reduce lending rates, making loans more affordable. However, it could also lead to a decline in fixed deposit (FD) interest rates, impacting investors who rely on FD returns.

Fixed deposits (FDs) and debt mutual funds are two popular investment options, each catering to different financial goals and risk appetites. While FDs offer guaranteed returns with minimal risk, debt mutual funds provide market-linked returns with the potential for higher yields. Here’s a detailed look at both investment options.

What Are Debt Mutual Funds?

Debt mutual funds are investment funds that primarily invest in fixed-income securities such as government bonds, corporate bonds, treasury bills, and money market instruments.

• Market-Linked Returns:

While relatively stable, returns depend on interest rate movements and bond market performance.

• Potentially Higher Yields:

Debt funds often provide better returns than traditional FDs, especially in a declining interest rate environment.

• Liquidity & Flexibility:

Investors can redeem debt mutual fund units anytime, although some funds may have exit loads for short-term withdrawals.

What Are Fixed Deposits?

Fixed deposits, also known as term deposits, are a secure savings option provided by banks and financial institutions. Investors deposit a lump sum for a fixed tenure—ranging from a few months to several years—at a predetermined interest rate.

• Guaranteed Returns:

The bank assures a fixed interest rate, making FDs a safe choice for conservative investors.

• Low Risk:

Since FDs are not affected by market fluctuations, they are ideal for individuals seeking stability in their savings.

• Limited Liquidity:

Early withdrawals from FDs may attract penalties, making them less flexible compared to market-linked investments.

Choosing Between Fixed Deposits and Debt Mutual Funds

The choice between FDs and debt mutual funds depends on an investor’s financial goals, risk tolerance, and investment horizon. While FDs are best suited for risk-averse individuals seeking stable returns, debt mutual funds can be a better option for those willing to take moderate risks for potentially higher gains.

Both options play a vital role in a diversified investment portfolio, balancing stability and growth based on market conditions and personal financial strategies.

Debt Funds Gain Appeal Amid Falling Interest Rates

The rate cut has brought debt mutual funds into the spotlight. When interest rates fall, bonds with higher coupon rates within debt funds become more valuable, as they continue to offer higher returns compared to newly issued bonds.

This increase in bond prices boosts the Net Asset Value (NAV) of debt funds, making them an attractive investment option.

Factors To Remember Before Investing in Debt Funds or Fixed Deposits

Debt funds and fixed deposits are two of the most popular investment options, catering to different financial needs and risk profiles. Here’s a detailed comparison based on risk, returns, liquidity, and tax efficiency:

1. Risk and Reward Ratio 

Debt Mutual Funds: These funds are market-linked and typically offer returns in the range of 7-8%. In favourable market conditions, debt funds can outperform FDs, albeit with moderate risk.

Fixed Deposits: FDs are low-risk investments offering stable returns of around 6-7% annually. Their returns are independent of market fluctuations, making them a safer option for risk-averse investors.

2. Liquidity

Debt Funds: Highly liquid, debt funds can be redeemed at any time. However, some funds may charge an exit load for short-term redemptions.

Fixed Deposits: FDs are less flexible, with early withdrawals often incurring an interest penalty of 0.5-2%.

3. Tax Efficiency

Recent tax changes have levelled the playing field between debt funds and FDs. Both are now taxed according to the investor’s income tax slab rate.

However, debt funds may still offer better post-tax returns for investors in lower tax brackets, especially when invested in tax-saving funds.

Debt Funds Outperform Bank FDs in the Last 2 Years 

According to the news report, over the past 2 years, approximately 215 debt mutual funds have outperformed the 7% interest rate offered by the State Bank of India (SBI) on fixed deposits, showcasing their potential as a lucrative investment option.

Leading the pack, DSP Credit Risk Fund delivered the highest return of 11.65% over the 2 years, followed closely by Aditya Birla SL Credit Risk Fund, which provided a return of 9.45% during the same timeframe.

In the last year alone, the performance of debt mutual funds has been even more impressive, with 254 funds surpassing bank FD rates. Among these, around 18 funds achieved double-digit returns.

Aditya Birla SL Credit Risk Fund emerged as a top performer with a 12.13% return in the past year, while HDFC Long Duration Debt Fund and SBI Long Duration Fund followed with returns of 11.91% and 11.74%, respectively.

Other notable performers over the 2 years include SBI Long Duration Fund, which delivered a 9.44% return, and Aditya Birla SL Long Duration Fund and DSP Strategic Bond Fund, each offering an 8.88% return.

Additionally, Bandhan G-Sec-Constant Maturity Plan and Bandhan G-Sec-Invest posted returns of 8.67% and 8.66%, respectively, while Kotak Savings Fund and Invesco India Medium Duration Fund each provided a 7.01% return during the same period.

Conclusion

The RBI’s decision to cut the repo rate after five years of maintaining the status quo has set the stage for a shift in the investment landscape.

While borrowers may benefit from lower lending rates, investors are likely to find debt mutual funds increasingly attractive, especially in a falling interest rate environment.

However, as with any investment, a balanced and diversified approach remains key to managing risks and optimising returns.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. This does not constitute a personal recommendation/investment advice. It does not aim to influence any individual or entity to make investment decisions. Recipients should conduct their own research and assessments to form an independent opinion about investment decisions.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing.