The bank deposit has been the instrument of choice for generations of low-risk investors. However it is becoming harder and harder to ignore the possibilities presented by debt funds. The two serve a similar function and are close rivals. The primary areas of difference are returns, safety, taxation, and liquidity, with mutual funds having the advantage in terms of tax-adjusted returns, and fixed deposits in terms of safety.
Bank Deposits are one of the safest avenues for savers in India with an almost negligible chance of default (although there have been instances of co-operative and local banks defaulting). But with debt funds, as in the case of all mutual funds, there are no guarantees. Returns are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds the fund has invested in. This is a legalistic interpretation of the safety of your investments in mutual funds.
In practice, the fund industry is closely regulated and monitored by the Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep a tight rein on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund's declared goals. These measures have proved to be highly effective but there have been some problems in the past, say, with JSPL, Amtek Auto and more recently with IL&FS and DHFL. Another common risk faced by debt funds is interest rate risk with funds losing value in a rising rate scenario and vice versa. Fixed Deposits which have been locked in for long tenures also face this risk in terms of opportunity cost, but there is no actual loss of value when the deposit is held to maturity.
The other big difference is that of taxation. Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this takes away a large chunk of their returns. Banks also deduct TDS on interest income from fixed deposits. The tax rates are similar for debt funds held for 36 months or less (though TDS will not generally be deducted). However for debt funds held longer than 36 months, returns are classified as long-term capital gains and are taxed at 20 per cent with indexation.
Turning to liquidity, open-ended debt funds' proceeds are credited within a period of two to three working days depending on factors such as whether an ECS mandate is registered. Fixed Deposits are also typically available at a one-to-two-day notice, but usually carry a penalty if they are redeemed before the maturity date. Debt funds have exit loads or charges that are usually levied for redemptions, typically up to 1 year. These exit loads are not applied to liquid funds with just a few exceptions for very short periods of time.
As the returns of debt funds demonstrate, you can beat the bank by investing in debt funds. Investors assume both credit risk (lending to riskier borrowers) and interest rate risk (the risk of bond prices falling when interest rates rise) and are hence compensated by higher returns. You should be cognizant of the risks involved and choose the right fund in order to get the best possible deal