Bonds vs Fixed Deposit
Bonds and fixed deposits are both saving instruments offering a fixed rate of return - both form a part of a diversified portfolio of investments. Indians have traditionally preferred the fixed deposit as a saving avenue. However, there are some innate differences between the two modes of investment. Let's analyse the differences between fixed deposits and bonds.
Fixed Deposits
- A fixed deposit is a saving instrument in which you deposit your money for a fixed period in return for a fixed rate of return.
- The returns on a fixed deposit, called the interest on the fixed deposit, can be paid either in instalments over the life of the fixed deposit or as a cumulative sum of return on the maturity of the fixed deposit.
- Fixed deposits are typically offered by banks, NBFCs and other financial institutions. The rate of return on the fixed deposit, called the interest, is fixed before the commencement of the fixed deposit. This interest rate remains the same during the fixed deposit tenure, irrespective of the change in the market interest rate. Fixed deposits are used to fund the loan obligations of banks and financial institutions.
- You can obtain a loan against your FD by pledging your fixed deposit and paying a preferential interest rate on your loan or overdraft.
- You have the flexibility to choose your tenure in the fixed deposit,
- Senior citizens are given a slightly higher interest rate on a fixed deposit.
- The interest rate on a fixed deposit is better than the interest rate offered on a savings deposit.
- Fixed deposits are considered low risk, safe modes of investment.
- They are not immune to interest rate changes on the maturity of the deposit if you want to roll them over.
- Early redemption of fixed deposits may result in a pre-payment penalty.
Investment Bonds in India
- Bonds represent the borrowed capital of companies and entities, whether sovereign or corporate.
- Investment bonds in India can be sovereign bonds (issued by the Government of India) or corporate bonds.
- Bonds have a fixed tenure, i.e., you cannot choose the tenure of investment.
- Bonds have credit ratings issued by credit rating companies. The higher the rating, the safer and more creditworthy the bond is.
- Bonds pay interest as a return in fixed intervals; this can be quarterly, semi-annual or monthly.
- Bonds are more volatile in that changes in the market interest rates can affect the prices of the bonds. If the market interest rates increase, the bond prices decrease and vice-versa. This means there is scope for capital appreciation/depreciation.
- Bonds can default on payments to bondholders. It is better to buy higher rated bonds to avoid a credit default event.
- Bonds have a secondary market and can be bought/sold before maturity. Depending on the bond yield and market interest rates, you can buy a bond at a premium or a discount on its face value.
- Bonds are secured by the underlying assets of the entity.
Analysing Bonds versus Fixed Deposit
- Safety of capital: If you place your fixed deposits with a higher rated bank or financial institution, you can be assured of the security of your capital. Sovereign and higher-rated corporate bonds usually do not default. In the case of bonds of companies with a lower rating, there is a risk of a credit default event.
- Interest payment frequency and flexibility of tenure: You can choose the tenure you want to invest in a fixed deposit. You can also choose the frequency of interest payments to you. In bonds, both the maturity of the bonds and the frequency of interest payments are pre-determined by the company. Interest payment frequency can be bi-annual or annual, depending on the bond's issuer.
- Premature exits: In the case of a fixed deposit, premature redemption attracts a pre-payment penalty in lower interest payments. In the case of bonds, you can easily exit by selling the bonds in the secondary market where they are listed. While comparing FDs versus bonds, exits are possible in both, but each has its own peculiar features.
- Rating: Most banks and NBFCs have a short term rating issued by one of the credit rating agencies. In the case of bonds, a rating is mandatory by one of the accredited credit rating agencies before the issue. It is better to remember that the higher the rating, the greater the safety of capital and interest payments and the lower the credit default risk.
- Interest rate risk: In the case of FD Vs Bonds, bond prices are more susceptible to interest rate risk than fixed deposits. This is the risk of the changes in the bond prices with changes in the market interest rates. Fixed deposits are also exposed to interest rate risk. On maturity of the fixed deposit, the interest rate at which the fixed deposit is rolled over may be lower if there has been a reduction in the market interest rates. In the case of Bonds versus Fixed deposits, it is better to remember that neither bonds nor fixed deposits are completely immune from interest rate risk.
Taxation of Interest income: Both fixed deposit and bond interest are subject to tax. There is a special category of bonds whose interest is tax-exempt. But in most bonds, the interest income is taxable.
Bond Fund versus Fixed Deposit
You can also buy bonds through a bond fund. A bond fund is a portfolio actively managed by a fund manager for interest rate and credit default risks. As a bond fund holds multiple bonds, it helps diversify away from the security-specific risk. There is also the oversight of a fund manager actively managing the bond fund. Bond fund yield/returns can be relatively high compared to holding individual bonds or fixed deposits.
Key Takeaways
Whatever the medium of investment, it is essential that you maintain a diversified portfolio. Both bonds and fixed deposits may form part of your portfolio's liquidity/fixed income-generating part. The allocation to each component depends on your risk-return profile and need for liquidity.
Shriram Finance enjoys a good credit rating and offers a superior yield on its fixed deposits and bonds compared to other banks and financial institutions.
