There probably isn’t a person alive who will say no to money that comes in regularly like clockwork. Even better if the money comes from a one-time, low-risk investment so they can easily make some hay while the sun shines.
Low risk means that the investor’s probability of losing their money is low, and the probability of earning a fixed return is almost guaranteed. These investments are ideal for investors with low-risk tolerance. In India, two of the most popular low-risk, fixed-income investments are corporate bonds and bank fixed deposits (FDs).
In this article, we will explore the similarities and differences between bonds and FDs. If you plan to invest in either instrument, the below information will help you to make the best possible choice for your investment goals.
What Are Bonds?
Bonds are considered a low-risk investment because they yield a fixed income. Companies and governments issue bonds to borrow money from individual or institutional investors instead of borrowing from a bank or other institutional lender in order to execute a new project, buy new equipment, or expand their operations.
Bonds can have different maturity periods, payout periods, and interest payouts. They can also have a different face value, which is the rupee value of the bond as stated by the issuer and the amount the investor will receive when the bond matures.
Most Indian bonds have a face value of Rs. 1000.
What Are Fixed Deposits?
Fixed deposits are also known as term deposits and are offered by banks and non-banking financial institutions (NBFCs) instead of companies or governments. In return for an investor’s lump sum, the bank pays interest at a certain rate. When the FD matures, i.e., at the end of its tenure, the investor receives the principal plus compound interest.
Unlike market-led investments, FD returns do not fluctuate over time, making them ideal for investors looking to save money and earn a steady income.
Some FDs also offer good returns, depending on the issuer and deposit type. Nonetheless, these returns are always lower than the returns possible from high-risk investments like equity. FDs, therefore, are ideal for investors who:
- Have a very low-risk appetite,
- Expect returns to not be impacted by market fluctuations, or
- Aim to build long-term wealth (SHAMBO: don’t agree, aim to preserve wealth, rather than build wealth, given that post tax and post inflation, real return is possibly going to be negative. Savvy investors must understand the role of tax and inflation before investing their savings into fixed deposits.)
Bonds vs Fixed Deposits: A Head-to-head Comparison
Both bonds and FDs are fixed-income debt instruments that represent a loan contract between lenders and borrowers. These similarities notwithstanding, there are many differences between these instruments. Let’s explore them in detail.
Issuer
A bond can be issued by a public or private company, a government, or a municipality when they want to borrow money from investors. In return, they make a legally-binding promise to pay interest on the principal and return the principal when the bond matures. In contrast, FDs in India are always issued by banks and NBFCs.
Safety/Risk
Although FDs and bonds are considered safe fixed-income investments, they are not completely risk-free.
Bond risk can be moderate or high if the issuing company is not financially stable or if a credit rating agency deems that their default risk is high. Bond risk also depends on the physical assets backing them.
Usually, bank FDs are low-risk because they don’t depend on market conditions to determine investor returns. That said, like bonds, FDs also carry some risk if the bank is not financially stable.
In recent years, some Indian cooperative banks have folded suddenly, leading to defaults and FD losses for investors. Per an RBI mandate, FD investors are eligible for deposit insurance of up to Rs. 5 lakhs. Principal and interest amounts above this threshold face default risk and losses.
Tenure
Some banks and NBFCs offer FDs for ultra-short tenures or terms of 7-14 days. The maximum FD tenure is 10 years. Tax-saver term deposits have a lock-in period of 5 years, meaning the investor cannot withdraw the money before this period.
The tenure of bonds depends on the issuer. For example, the Government of India issues bonds for 5 to 40 years. Companies may issue bonds for shorter or longer periods based on their purpose and target amount.
Liquidity
FD liquidity depends largely on tenure since it determines when you can recover your principal. Thus, if you open an FD for 7 days, you can recover the principal very quickly, which makes your funds highly liquid. However, longer-tenure FDs mean that the principal is tied up for longer, reducing liquidity.
If you require sudden liquidity, you can prematurely withdraw your FD. However, you will lose out on future interest and may also have to pay the penalty to the bank.
Bonds that are frequently traded or traded at high volumes on a stock exchange will have stronger liquidity, meaning you can easily sell them for cash. Other bonds are usually less liquid, so you may find it harder to sell them.
All bonds are subject to liquidity risk, which means you may not always receive a price reflective of its true value. Furthermore, bond liquidity comes at the cost of market volatility since interest rate movements in the market impact bond prices and the ultimate price you will get for selling the bond.
That is to say, a seller may not receive a price at which he/she wishes to sell the bonds because the price is dependent on market-wide liquidity constraints and ability of buyers to pay the ask price.
Interest Rates
The interest rate on low-tenure FDs is always lower than the interest on higher-tenure FDs. This is because the higher interest is the “price” the issuer pays in return for using your money for a longer period.
Bond interest rates depend on the issuer. A stable company that’s unlikely to default will generally offer lower rates because your risk is low, while unstable companies will offer higher rates to compensate for your increased risk of potential loss. Just like an FD, a bond with higher tenor will come with a higher interest rate. This is called the term premium.
Credit rating
Credit rating agencies like CRISIL, ICRA, and CARE issue credit ratings to bonds and NBFC-issued FDs.
The credit rating of bonds can vary from investment-grade to junk. Bond issuers must specify the rating when issuing a bond to potential investors. Banks are not required to provide credit ratings for their FDs.
Different agencies use different scales to rate a bond as investment-grade (low risk), junk (high risk), or something in between (moderate risk).
For example, S&P and Fitch rate investment-grade bonds as AAA rating while Moody’s uses a rating of Aaa. Similarly, the junkiest of junk bonds are rated as D by S&P and Fitch. Other bonds also earn ratings between AAA and D, depending on their risk profile.
Taxation
FD interest earnings are taxable depending on the investor’s tax slab. In general, investors younger than 60 years must pay tax on FD interest earnings. The exception is tax-saving FDs.
Senior citizens (60+) are exempted from paying taxes on any FDs under Section 80 TTB for interest earnings under Rs. 50,000.
In India, the interest earned on bonds is generally taxable unless specified by the issuer. As of September 2022, long-term capital gains from listed bonds are taxed at 20%. Here, long-term means a bond held for longer than 12 months. As of August 2022, short-term bond interest is taxable at 30% plus surcharge and cess.
Should You Invest in Bonds or Fixed Deposits?
Both bonds and FDs are fairly safe instruments and, therefore, suitable for investors:
- With low-risk tolerance
- Who wants to earn a fixed income
- Who prefers a lower risk of loss of capital over higher returns
- Whose primary goal is wealth building but has very low risk-tolerance and wants to remain within the safety of the banking system
- Who have limited knowledge/experience in the stock market
These instruments assure that the investor will also earn a regular return at specific time intervals and get their principal back on maturity.
Corporate bonds are backed by some physical collateral, further reducing the investor’s risk. FDs are not backed by physical assets.
However, they are issued by banks or NBFCs that are licensed to operate in the Indian market and regulated by the RBI. Further, FD returns are not hampered by market fluctuations. For all these reasons, FDs are also a safe investment option.
However, bonds and FDs are not suitable for investors who have a high-risk appetite and are unwilling to accept the low-risk-low-reward profile of these instruments.
Yubi Invest: Simplifying Fixed-Income Investments
We hope you found this head-to-head comparison of bonds and FDs useful. Ultimately, the “better” choice would depend on your investment goals, horizon, and investable corpus. Consider all these factors and choose wisely!
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