Bank deposits vs debt mutual funds

Bank Deposits vs Debt Mutual Funds is a false dichotomy. One is not a replacement for the other. Most of us need both. Yet, people constantly compare them because they both seem to serve the same purpose.

A bank deposit is a way to hold cash. Holding cash means it’s for a short-term need (which includes potential short-term needs such as an emergency fund).

A debt mutual fund is a way to add stability to a long-term investment portfolio. It’s main purpose is not to hold cash, but to act as a shock absorber.

Slide from a recent talk I gave on debt mutual funds (click to enlarge)

Bank deposits shield you from the capital loss risk. Scheduled commercial banks regulated by RBI have never lost a single rupee of depositor money. The confidence investors have with bank deposits is well-earned and well-deserved. However, capital loss is not the only thing an investor should be considering.

Disclosure: I am biased against bank deposits. Please keep that in mind when you read the rest of this post. I try to be objective, but knowing my bias can help you make a better decision for managing your own money.

Concentration risk

You may trust your bank with a small sum. You may feel confident that they’ll return the money when you ask for it. But there is a point at which you start to feel uncomfortable. That number could be a few lakhs for some and a few crores for others. But we all start to feel jittery when the size of the deposits grow beyond a certain size. Debt mutual funds alleviate this concentration risk by deploying our money in dozens of different securities.

Tax drag

You may make a deposit that pays 8% return on your deposits. But if you are in the 30% tax slab, your effective return is only 5.6% after paying tax every year. Someone with a sizeable fixed income portfolio can save a significant sum just by avoiding tax payments every year.

Let’s think of a hypothetical bank deposit that pays 8% return and compare it with a hypothetical debt fund that appreciates by 8% per year. Imagine an investment of ₹1,00,000 made by an investor who falls in the 30% tax slab. At the end of 10 years, the bank deposit would have grown to ₹1,72,440 (after taxes). The same principal would have grown to ₹1,81,124 (after taxes) if invested in our hypothetical debt mutual fund.

While this ₹9,000 may not look like much, the difference becomes more pronounced with longer holding durations. For 25 years, the final corpus values are ₹3,90,479 and ₹5,09,392 for bank deposit and debt mutual fund respectively. (If 25 years sounds unrealistic, ask yourself: how long does your retirement portfolio need to last?)

Chart created at canva.com

Manual vs automatic

Bank deposits are too manual, and require maintenance. Every time you have money to invest, you need to decide whether to make a 1 year deposit or a 5 year deposit. If you get that duration wrong, you may need to pay a penalty when you prematurely withdraw your bank deposit. Every time you need to take money out, you need to decide which deposit to liquidate. No such hassle with debt mutual funds. You invest and redeem as and when you need; no penalty for misjudging when you need the money.

Bank deposits are a great source of FOMO (fear of missing out) when interest rates rise. Many people had made bank deposits during Covid when the interest rate was low. When the RBI hiked interest rate, they all had a conundrum—whether to prematurely close their previous deposit or not. No such hassle with a debt mutual fund. Your money will earn “market interest” irrespective of whether the rate rises or falls.

Better visibility of where your money is

If you invest in a debt mutual fund, the AMC will disclose the fund’s portfolio with you every 14 days. You can clearly see how much of your money is lent to whom. If you don’t like what you see in that list, you have the power to move your money to a different fund.

With bank deposits, the traces of “your money” is completely lost. Your money becomes a part of the very large pool of liabilities that the bank has. That is not necessarily a huge risk considering that banks have not lost depositor money. But something for you to consider and decide what makes you feel better.

Potential to take higher/different risks

There are many different categories of debt mutual funds that let you choose exactly what you want. Do you want to avoid credit risk as much as possible? Invest in a gilt fund. Do you want to earn a bit more return by lending to private borrowers? Invest in a corporate bond fund. Do you want an asset that’s as close to a bank deposit but in the form of a mutual fund? Invest in a liquid fund. (Disclaimer: quality of funds can wildly vary within every category.)

So many debt mutual fund options exist because different investors want different assets for their portfolios. Bank deposits, on the other hand, are all the same: you deposit money today, and the bank returns it after the agreed upon time has elapsed.

What is the flip side of this? It is possible for an investor to pick a wrong mutual fund that doesn’t suit them; no such risk with bank deposits because they are all the same.

• • •

All these differences should tell you where each asset fits: bank deposits are to hold cash. You don’t care about optimising the return; you pay a high tax for the capital preservation safety; you pay an inconvenience fee to the bank in case you change your mind and want your money back prematurely.

Debt mutual funds are for long-term holdings. You don’t really need that money in the next few years; you appreciate the bouquet of options that you can choose from; you are willing to reduce the capital preservation safety by a tiny bit in exchange for letting a fund manager manage the money.

One is not a replacement for the other because they serve different needs. Choose what works for you based on what you need, and what makes you feel at ease.