Which mutual fund can I use as a fixed deposit replacement?

Last Updated on January 9, 2022 at 12:35 pm

A viewer on our YouTube channel asks, “Sir, are conservative hybrid funds a good alternative for FD? Especially the Parag Parikh Conservative Hybrid Fund. They seem to be investing only in govt bonds, and for stable returns, they are investing in dividend stocks like ITC and coal India. is this fund safe?”

Let us expand this question to ask which mutual fund can be used as a fixed deposit replacement. Technically, we cannot compare a fixed deposit with any mutual fund. And no mutual fund is a replacement for a fixed deposit.

From a practical point of view, our parents invested only in fixed deposits, but we have now “replaced” with equity mutual funds (hopefully) for long term goals (10+ years away). The point is, we can replace one product with another provided we have the right expectations about it. 

We all desire higher returns at a lower tax. While this is possible with mutual funds, we must completely abandon the idea of “safety” or “safety of the amount invested”, to be exact. Mutual funds are not a suitable investment unless we are ready to do this.

Knowing when to invest in which mutual fund is crucial. We know when the risk to the amount invested is reasonable or not.

Finding an FD replacement for short-term (< 5 years) and medium-term goals (5-10 years) is a lot more difficult as one should choose debt funds for these, and that is a lot tougher than choosing equity funds.

So here are some simple thumb rules for debt mutual fund selection

1. Check the average portfolio maturity of the fund. This is the weighted average maturity period of the bonds in the portfolio. Higher this number, the higher the NAV fluctuations.
2. Ensure the average portfolio maturity of the fund is much lower than your goal tenure. For example, if you need money in five years, choose debt funds with average portfolio maturity of about 1Y or less.
   • Many “advisors” claim the average portfolio maturity of the fund should match the investment tenure. This is rubbish. See: Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile
3. The only exception to this rule is gilt mutual funds which should only be used for long term goals.
   •  FAQ on gilt mutual funds: essentials investors should know
   • Gilt funds vs Dynamic Bond Funds vs Corporate Bond Funds: Which is the better choice?
4. Then comes the credit rating of the bonds in the portfolio. Here, one should look at the entire portfolio, not the average credit rating.
   • Our debt mutual fund screener published each month allows this comparison for debt and hybrid funds across categories.
5. Gilt funds used for long term goals to a large extent avoid the possibility of credit defaults. However, technically a gilt fund can invest in risky bonds up to 20% of the portfolio!
   • Also, see: How to choose a gilt mutual fund.
6. Assuming an investor wants to avoid credit risk entirely, then liquid or money market funds are the way to go for short-term and medium-term goals. Although these funds can take on credit risk, finding a style-pure fund in these categories is easier than anywhere else.
   • Arbitrage mutual funds can also be used as a substitute for liquid or money market funds. However, these funds are not classified as hybrid funds and can hold up to 35% in bonds (typically) short-term, and some may carry credit default risk. See: Can we use tax-free gains from arbitrage MFs for short-term needs?
7. One can look beyond money market funds for medium-term goals, but the space there is so messy it is hard to find funds that take on little or no credit risk. Those who can stomach some credit risk can consider an ultra short term fund. Beyond this, the diversity within a category is too much and retail investors are better off without them.
   • If and when interest rates increases, liquid and money market funds will benefit and are a better choice than floating rate funds: Should we invest in floating-rate MFs to benefit from interest rate hike?

Now, what about the fund mentioned by the reader? We have written about this earlier – Who should invest in Parag Parikh Conservative Hybrid Fund?

The fund has already seen instances of negative monthly returns. So it is certainly not “safe”, and those who do not understand the at least above mentioned nuances of debt funds should not invest in this.

The fund has an average maturity of 6.35 years as of Nov 2021. This means it is only suitable for long term goals. It will be quite volatile if used for shorter periods, and hence the uncertainty on returns will increase.

In summary, finding fixed deposit replacement in mutual funds is possible only if we appreciate the primary risks in a fund and if these are reasonable for the duration of our investment. Looking at returns is not the way to shop for mutual funds.