Are debt mutual funds better than bank fixed deposits?

A friend of mine read my post on debt funds and asked me this question. “If you shouldn’t be optimising your debt portfolio for return, why not just put the money in bank fixed deposits (FDs)? Are there reasons to choose debt mutual funds over bank FDs?”

A very good question. Putting higher returns aside, are there reasons to invest in debt mutual funds rather than investing in FDs?

I can think of the following reasons:

• Diversification. With an FD, you trust that a certain bank (or a few banks) will be able to repay you. It’s arguably not a huge risk that a bank will go insolvent, but the risk is nonzero. With debt mutual funds, your money is invested in several bonds/CDs/CPs/etc so the risk of any one—or a few—institutions going insolvent is mitigated. You might lose, say 5% of your capital but not 50 or 70%.
• Convenience. If you were to invest in FDs, you need to decide which bank, for how long, etc at the time of investment. When you buy debt mutual funds, you don’t need to make those decisions. The fund manager makes those decisions for you. You pay the fund manager for this work, of course, through the fund’s expense ratio. But the convenience is worth the money in my view.
• Income tax. If you have an FD for 10 years, you’ll be paying taxes every year for the accrued interest. With debt funds, you don’t have to worry about taxes until the time you redeem the funds. Also, taxation of long term debt mutual funds is not at slab rate, which can be a big plus for people who are in the highest tax bracket; it’s less of an issue for people with low tax liability.
• Restrictions imposed by FDs. This is just a combination of convenience and rate of returns. Let’s say you have 10 lakh rupees in 10 FDs: 1 lakh each. You need to withdraw ₹70,000 for some expense. Now you can break one FD and re-deposit the balance ₹30,000, but you’ll lose any unpaid interest for the deposit, including for the ₹30,000 you will be re-depositing. You can maybe ignore the interest loss, but you really have to think and decide how to reinvest this ₹30,000. For example, how long to invest, should this be a single ₹30,000 deposit or a few deposits of lesser amounts, etc. If the same 10 lakhs was in a debt mutual fund, you simply redeem ₹70,000 and that’s the end of the story.