Bonds vs Fixed Deposits
The main difference between bonds and fixed deposits is that bonds are a type of debt instrument, while fixed deposits are a type of deposit. Bonds and fixed deposits are the most popular fixed investment products in India. This also makes them the two most compared investment options among Indians.
Both the instruments offer stable income and capital protection. They are much safer than stocks and easy to invest in these days.
However, several differences separate the two investment options. In the following paragraphs, we will help you understand these differences.
Bonds vs FDs: Definition and Interest Rates
Bonds and fixed deposit comparisons are the most frequent because of how similar they are. Both have the following features:
- Fixed income instruments
- Low risks
- Predictable returns
Below we will discuss and highlight the differences and similarities between bonds and fixed deposits. We’ll also discuss whether you should invest in bonds or fixed deposits.
First, let’s understand bonds and FDs in some detail.
What are Bonds?
Bonds are loans given by bond buyers (or investors) to bond issuers.
Typically, bonds are issued by governments and corporations (public and private sector companies) to finance projects or strengthen balance sheets.
Bonds are purchased by people and institutions who want to grow their money. Retail investors, HNI investors, mutual funds, pension funds and foreign institutional investors invest in bonds to generate returns.
Bonds Interest Rates
Bonds have multiple attributes like type of instrument (bond/debenture), issuer category (government/corporation), credit rating, tenure etc.
Based on these attributes, issuers issue bonds at different interest rates. For example, a bond with a high credit rating will offer a lower interest rate than one with a lower credit rating.
T-bills (Treasury bills) are short-term instruments issued by the Government of India. The yield on these right now (Jan 2023) is around 6.5%.
On the other hand, yields of long-term BBB rated bonds issued by moderately risky private sector companies are around 12% right now.
It is important to note that bond returns are fairly predictable but not fixed. Further, the returns are predictable only if the bond is held until maturity. Early withdrawals from bonds bring in many other complexities.
What are Fixed Deposits?
While almost everyone knows and invests in FDs (fixed deposits), not everyone understands what happens with their money behind the scenes.
Banks accept fixed deposits and conduct their lending business using the deposits. Simply put, banks pay us a certain interest rate on our deposits and lend that money to borrowers at a higher interest rate. That’s how they generate profits.
Fixed Deposit Interest Rates
Unlike bonds, FDs offer a fixed interest rate.
Fixed deposit interest rates are relatively simpler than bond interest rates. Most banks offer similar FD interest rates. Some banks may offer a higher interest rate than others to attract depositors, but they are usually smaller banks with little brand recognition.
Only one important factor determines fixed deposit interest rates: tenure. Banks have a preference for different tenures at different times. At times banks may be looking for fixed deposits for 1-2 years, while they may prefer fixed deposits for 4-5 years. Nevertheless, the shorter the period, the lower is the interest rate offered.
Here are the fixed deposit interest rates offered by a few Indian banks right now:
|Bank Name||Tenure||FD Interest Rate*|
|State Bank Of India||6 Months||4.50%|
|HDFC Bank||6 Months||4.50%|
|Axis Bank||6 Months||4.75%|
|AU Small Finance Bank||6 Months||5.00%|
*As of January 2023
Bonds vs FDs: Investment Safety
Bonds and FDs are considered to be safer investment options than equity or stocks. However, not all bonds and FDs are equally safe.
FDs are safer than bonds because FDs are insured up to Rs. 5 lahks by DICGC (Deposit Insurance and Credit Guarantee Corporation), a subsidiary of the RBI.
The insurance is applicable on both the principal and the interest for all depositors at each bank.
Let’s look at the following scenario to understand this better.
Ajay has Rs. 6,00,000 FD at a commercial bank. If the commercial bank shuts down and the bank is unable to return the deposit, DICGC will give Rs. 5,00,000 to Ajay.
Had Ajay deposited Rs. 1,00,000 at one commercial bank and Rs. 5,00,000 in another commercial bank, the DICGC would have paid Ajay Rs. 6,00,000 because the Rs. 5,00,000 limit applies to each depositor at each eligible bank.
It is important to note that DICGC insures only commercial and cooperative bank FDs. Deposits made at cooperative societies are excluded because they are not regulated by the RBI.
Are bonds safer than FDs?
Bonds have varying safety levels depending on the issuer (government/PSU/private sector companies) and other attributes like credit rating, tenure and security.
Bonds issued by state and central governments are considered to be the safest as they carry a sovereign guarantee of repayment.
The safety of corporate bonds issued by PSUs and private sector companies can be judged by their credit ratings. Credit ratings are awarded by credit rating agencies like CRISIL, CARE, ICRA etc.
A credit rating of AAA is considered to be the highest. Bonds issued by most PSUs, large banks and reputed companies with long legacies are AAA-rated.
On the other hand, a credit rating of D is considered to be the lowest. A credit rating agency awards a D credit rating when the issuer defaults or is very likely to default soon.
Long-term bonds are considered to be riskier than short-term bonds. This is because long-term bonds are more sensitive to interest rate movements.
It is easy to see that bonds are riskier than FDs because bonds have a variety of risks, unlike FDs. Even government bonds have risks associated with interest rates.
However, the extra risk that investors take by investing in bonds can yield higher returns if the risks are managed properly.
Bonds vs FDs: Minimum investment amount
Both bonds and FDs are easily accessible to investors.
To start an FD, you can simply log in to your net banking account or walk to your nearest bank branch. The process is simple and straightforward.
The minimum investment required for FD is just Rs. 1,000 at most PSU banks. Some private sector banks may ask you to invest Rs. 5,000.
Bonds, although easy to access, are not very easy. But the bonds market in India has become more inclusive recently. Websites like RBI Retail Direct and Dezerv enable you to invest in government securities and high-return corporate bonds.
The minimum investment required for bonds is just Rs. 10,000. This applies to most bonds. The minimum investment required for certain bonds may be as high as Rs. 10,00,000.
Another way to invest in bonds is through debt funds. A debt fund is a basket of fixed-income securities managed by a professional fund manager. The minimum investment required to invest in bonds through debt funds is just Rs. 500.
Bonds vs FDs: Early withdrawal and liquidity
Early withdrawals are possible in both bonds and fixed deposits. However, there are implications.
If you withdraw early from bonds, i.e. before maturity, you expose yourself to interest rate and liquidity risks. Both these risks may result in you not being able to realize the fair value of your bonds, thereby reducing your investment returns.
If you withdraw early from fixed deposits, the bank will charge you a penalty in the range of 0.5% to 1%. This means you will realize a lower interest rate than what you were promised had you stayed invested until maturity.
Liquidity refers to how quickly you can sell an asset for cash while realizing a fair market value.
Bonds may or may not be liquid, depending on the trading volumes. For example Government securities are quite liquid, whereas debentures issued by small companies may not be so liquid.
FDs are super liquid. You can place a withdrawal order on your net banking account, and the money will be in your savings account in a day or two. But remember that premature withdrawal will attract a penalty of 0.5%-1%.
Bonds vs FDs: Interest Payout Frequency
The interest payout frequency of bonds could range from monthly to yearly. Investors don’t have the option to choose the interest payment frequency. It is defined by the issuer during bond issuance.
Investors can choose the interest payout frequency of fixed deposits. They could also choose to receive cumulative interest on the maturity of the fixed deposit if they don’t want regular interest payouts.
Bonds vs FDs: Tenure
Tenure is the period from the issuance of an asset to the maturity of the asset. For example, equity or stocks have an indefinite tenure because stocks never mature.
Tenures of bonds range from a few days to perpetuity. However, perpetual bonds (bonds that pay interest forever) are outliers. For normal bonds, the tenure ranges from a few days to 40 years.
The tenure of fixed deposits ranges from a few days to 10 years.
Bonds vs FDs: Taxation
Taxation is an area where bonds really shine over fixed deposits. Let’s see how.
How are fixed deposits taxed?
Fixed deposits are taxed at the marginal income tax rate of the investor.
So, if you are in the 30% income tax bracket, the interest you receive from your FDs will be taxed at 30%. Tax treatment of fixed deposits doesn’t change based on tenure.
How are bonds taxed?
The taxation of bonds is slightly complex.
Firstly, profits from bonds are of two types: interest payments and capital gains. Interest payments are the regular payment you receive while you own the bond. Capital gains is the profit on the bond price that you may make by selling it before maturity.
Suppose you buy a bond for Rs. 100 with an interest rate of 8% paid annually. Rs. 8 is the interest you will receive every year. Now if you sell the bond before maturity in the open market, it is likely that the bond will be trading either above or below Rs. 100, the price you paid for it. Suppose you sell it while it is trading at Rs. 120. You will make a profit of Rs. 20 on the bond price: capital gains.
Secondly, bonds could be listed (on the stock exchange) or unlisted. Listed and unlisted bonds are treated differently from the taxation perspective.
|Listed Bonds||Unlisted Bonds|
|Tax On Interest Payments||As Per Marginal Income Tax Rate||As Per Marginal Income Tax Rate|
|Short-Term Capital Gains||Less Than 1 Year: As Per Marginal Income Tax Rate||Less Than 3 Years: As Per Marginal Income Tax Rate|
|Long-Term Capital Gains||More Than 1 Year: Flat 10% (No Indexation Benefit)||More Than 3 Years: Flat 20% (With Indexation Benefit)|
So, if you are in the higher tax brackets (20% and above), paying long-term capital gains on bonds will save you a lot of money when compared to paying income tax on FD interest.
Bonds vs FDs: Loan against securities
Did you know that you can take a loan by pledging your bonds and fixed deposits with a financial institution?
This means you can take a loan without liquidating your investments but giving the lender right over your investments in case you default on the loan.
Both bonds and fixed deposits are eligible instruments for loans against securities.
Haircut on loan against fixed deposits
If you pledge an FD worth Rs. 100 and take a loan, you will get a loan of Rs. 90 and not Rs. 100. The 10% difference between the FD value and loan amount is called haircut.
Alternatively, the percentage of the value of the loan you get is called the LTV ratio (loan-to-value ratio). In the example above, LTV is 90%.
Because of the super high safety, LTV of loans against fixed deposits is around 90-95%. This implies a haircut of around 5-10%.
Haircut on loan against bonds
Bonds, as we know, come in all shapes and sizes.
Bonds, although safe, are exposed to more risks than FDs. So, the LTV of loans against bonds ranges from 50-80%, depending upon the bonds you are pledging. In other words, the haircut on loan against bonds ranges from 20-50%.
The haircut on loan against government bonds will be lower than that on a loan against PSU bonds and bonds issued by private sector companies.
Another important point is that not all bonds can be pledged as collateral for loans against securities.
Bonds vs FDs: Tax-saving and exemption features
Specific bonds and FDs offer tax-saving and exemption features. But first, let’s understand the difference between tax saving and tax exemption.
Tax-saving refers to reducing your taxable income by investing money in specific assets. Most know about Section 80C which is an Income Tax Act related to tax-saving.
Tax exemption is when you don’t pay taxes on the profits of your investments. For example, when you liquidate your provident fund (PF) at retirement, you are not required to pay tax on it because PF is a tax-exempt instrument.
The following table discusses the tax-saving and tax-exemption features of bonds and FDs:
|Tax Saving||Until FY14, Infrastructure Bonds Helped Investors Reduce Taxable Income By Up To Rs. 20,000 Per Financial Year Under Section 80CCF. Presently, Tax-Saving Features Are Not Available On Any Bond.||Presently, 5-Year FDs Can Help You Reduce Your Taxable Income By Up To Rs. 1,50,000 Under Section 80C.|
|Tax Exemption||Earlier, Specific Bonds Enjoyed Tax Exemption Under Section 10. Presently, Tax Exemption Features Are Not Available On Any Bond||Fixed Deposits Are Not Tax Exempt. They Are Taxed As Per Your Marginal Income Tax Rate.|
Should you invest in bonds or FDs?
Honestly, it is difficult to answer this question in one word. But using the below framework, you can decide where to invest:
- If your investment horizon is very short (3-6 months), it is best to stick to fixed deposits.
- If your investment horizon is above 1 year, you can consider investing in bonds because of the taxation benefit. But you need to be mindful of the risks that apply to bond investing.
- If you are investing in bonds, find bonds that fit your risk profile. It’s essential to check the credit rating of the bond. If you have a low tolerance for risk, stick to bonds with AAA and AA credit ratings only.
- If you are investing in bonds, make sure that you are comfortable staying invested until the bond’s maturity date. Staying invested until the maturity date eliminates risks associated with interest rates and liquidity.
These are just guidelines and you should not solely rely on them to make an investment decision. It is recommended to get an expert’s advice to select the best bonds or fixed deposits for your money and financial situation.