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

In the last three quarters, the Reserve Bank of India has increased the repo rate by 225 basis points. It is the rate at which the RBI lends money to banks. As a result, the market participants (banks) had to increase the fixed deposit rates. How has it impacted the debt mutual fund? 

In the present scenario, which is the better option for the investors - fixed deposits or debt mutual funds? In this article, we will try to find the solution to this puzzle.

Understanding the macroeconomy

As mentioned above, the RBI has raised the repo rate by 225 basis points. However, if you check the FD rate offered by your bank, it has not increased in the same proportion. For example, the State Bank of India (SBI) used to give 5.20% on FDs with a one-year tenure in May 2022 (before the rate hike cycle started). In December 2022, the same FD offered 6.75% for the same tenure. It shows that banks have not passed on the benefits (only 155 basis points in this case) to the end users as of now.

Bond rates are inversely related to the repo rate. It means that whenever there is a repo rate increase (and a FD rate increase), the bond price falls. As a result, you may see that most debt funds have given poor returns in the last year. Does it mean fixed deposits are a clear winner? The equation is not that simple.

Understand the fixed deposit market

Two points you need to understand around fixed deposit returns:

• First, the banks have not yet passed the complete repo rate benefit to FD investors.
• The rate hike cycle is not over. According to experts, there could be another rate hike next month.

Based on these two points, one can conclude that investors can expect FD rates to increase further. Even if they don't increase, they will remain at the same levels for quite some time.

Understanding the Debt Mutual fund market

The debt funds have underperformed for 8 to 9 months, for the reasons we already discussed above. However, when the repo rate increases, there is a positive effect on debt mutual funds. Investors will start seeing the impact in the next few quarters. 

The yield to maturity (YTM) of underlying bonds will start rising - the potential returns can go up. YTM is the total return you will receive if all the scheduled payments are made on time, and you hold the bond until maturity.

We are at the peak (almost at the peak) of rate hike cycles. Soon the rate hikes will stop, and they may even start to come down. The negative impact on mutual debt will go away, and they will start performing well. For this reason, debt funds can be considered by investors.

The average returns of debt funds is 6 to 7% but you can see above it has come down in the last one year.

The tax benefits

Before you pick any asset, you must factor in taxation to understand the actual returns. 

In the case of fixed deposits, the interest you earn is added to your taxable income and taxed as per your tax slab. Therefore, if you are in the 30% tax bracket, your net returns are relatively low. However, if your tax slab is at the lower end, the actual returns can be high.

For debt mutual funds, you are taxed at 20% if you hold your investments for three or more years. You also get an indexation benefit, so the effective tax is less than 20%. With a holding period of less than three years, the debt fund gains are taxed as per your tax slab. 

Which is the better option?

At present, given the uncertainty around FDs and debt mutual funds, there is no clear winner. Investors can pick one (or both) based on their investment horizon, goals and factor in taxation to see what gives the maximum returns.

However, given the uncertainty, it is better to opt for FDs or debt mutual funds with a short duration. In fixed deposits, if rates go higher, you can reap the benefits by investing at higher returns. For debt funds, select schemes with comparatively shorter duration profiles.

This is not investment advice. Investments in the securities market are subject to market risk, read all the related documents carefully before investing. Past performance is not indicative of future returns.