How bonds and fixed deposits differ, and which one should you choose
Most ordinary investors wish to have assured returns on part of their portfolio. Fixed income investing not only brings in much-needed stability to the portfolio, but also ensures peace of mind.
Fixed deposits and bonds are among the most popular investments providing regular returns to investors. While the objective of the two modes may be similar, FDs and bonds have different features that investors need to understand before deciding which one to choose.
FDs, especially those issued by banks, have traditionally been the most favoured fixed income instrument for Indian households. However, the preferences as the bond market grows with more issuances and with increasing ease of investing, especially through the comfort of online investing, they also come up as an attractive avenue for safe and regular income.
Here we discuss the features of both the instruments and how they compare as investment alternatives.
Difference in features
Bonds are generally issued by governments, corporations and even municipalities to raise money. On the other hand, fixed deposits are generally issued by banks, post offices, housing finance companies and a few non-banking finance companies (NBFC).
There are various ways of bond issuance. They can be auctioned, privately placed or offered to the public at large through a public offer. A few bonds, such as RBI Floating Rate Savings Bonds, are available on tap through the year. Fixed deposits are available on demand. Rarely does an issuing entity like a bank stop accepting fixed deposits.
Fixed deposits can be renewed at the time of maturity in case investors want to continue earning interest on the invested amount. Investors can opt for an auto-renewal facility while booking a fixed deposit. However, the rate of interest offered on renewal may change depending on the market conditions.
Fixed deposit issuances generally have a minimum stipulated investment while there is no other restriction on the amount of money invested. Bondholders, however, are usually paid the principal and interest earned at the time of maturity and the bond is extinguished. The face value of the bond is predetermined and an investor has to buy in multiple of one bond minimum.
Bonds signal risk quantum to investor
The issuer has to mandatorily get a credit rating on their bond offering. The rating ensures investors get an idea of the risk involved in investing in a particular bond. A higher credit rating (say AA+ and above) indicates low credit risk. As one moves down the credit rating ladder, the interest rates on offer tend to go up to compensate investors for the additional risk they are willing to take.
While a similar credit rating is required for FD programs of NBFCs. No such requirement is mandated for banks and post offices.
Returns may differ
Bonds generally offer a tad higher return than fixed deposits. Returns vary as per credit rating, tenure and the underlying risk. Investors looking for higher return can consider investments in high yield bonds over bank fixed deposits.
Interest rate risk
Fixed deposits generally offer fixed rates of interest with no variation until maturity. bonds may or may not have fixed rate of interest. Bonds can ALSO offer floating rate of interest linked to an external benchmark. Also, the price of a bond can be impacted by interest rate movement in the system. When interest rates in the economy go up, the prices of the bond fall in the secondary market and vice-versa. This interest rate risk can inflict marked to market losses (as well as gains) on the investors holding the bonds.
The liquidity factor
A fixed deposit can be liquidated before the date of maturity in case the depositor is in need of money. The issuing entity may charge a premature penalty. A listed bond can be sold in the secondary market or can be sold through a mutually negotiated deal. Some bonds also have call and put options embedded. A call option allows the issuer of the bond to call back the bond on stipulated dates. On these dates the investor is paid back the capital as per stipulated terms. A put option allows the investor to sell the bond to the issuer on stipulated dates. If exercised by the investor, the issuer has to pay the investor the capital as per predetermined terms. An issuer of the bond can buy back bonds by making open offers to all bondholders.
Holding in demat account
Some bonds are listed and they must be issued in the demat form. Though demat account add to the cost incurred to invest, it ensures convenience and safe keeping of the bonds along with other investments. Fixed deposits are not issued in demat form. The issuing entity hands over a fixed deposit receipt either a physical copy or online receipt.
The backing of collateral
Bonds are of two types – secured and unsecured. Secured bonds have underlying assets which are sold to pay off the secured bondholders in case the issuer goes into liquidation. These bondholders have a claim on assets ahead of other claimants with unsecured debt. Unsecured bonds do not have earmarked collateral.
Fixed deposits are generally unsecured. However, bank fixed deposits up to Rs 5 lakh per depositor in each bank are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC).
Different in tax treatment
Interest paid on the fixed deposit is taxable as per income tax slab rate of the investor. Interest earned on the bonds is generally taxable in the hands of the investor, unless stated otherwise. For example, the interest payouts on the tax-free bonds are exempt from income tax.
An investment up to Rs 1.5 lakh in a 5-year tax saving bank FD in a financial year is tax deductible under Section 80C of the Income Tax Act.
Capital Gains Bonds, technically known as Section 54EC bonds, can be used by individuals to save on tax on long term capital gains booked on sale of property or assets.
Should you choose bonds or FDs?
There is no definitive answer for this question as both have their own pros and cons. Fixed deposits are generally easy to access and easy to break to gain liquidity. However, bondscan bring in a much needed income boost. A carefully crafted bond portfolio, especially of high yield bonds can reward savvy investors over the short to medium term. Investors must take into account their financial goals, risk taking ability, and the risk reward associated with bonds while investing in them.
Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.