Bonds and fixed deposits are both fixed-income instruments, which pay fixed returns at periodic intervals or make cumulative interest payments on the maturity date. However, these fixed income options can differ significantly in terms of returns, risk, liquidity, taxation, etc. Understanding these differences can help you make informed decisions while choosing between fixed deposits and bonds.
Returns
Just as in the case of fixed deposits, returns generated from bonds held till their maturity dates would consist of the interest payments received at pre-set periodic intervals or cumulative interest payments received on their maturity dates. However, listed bonds traded on stock exchanges may witness price gains due to falling interest rates, credit rating upgrades or other favourable market conditions. Thus, investors of listed bonds can also benefit from rising bond prices by selling them in the stock exchanges before their maturity dates.
Risk
While bonds offer the scope of generating additional returns through capital appreciation, factors like rising interest rates, credit rating downgrades or other unfavourable market conditions may also lead to a fall in the bond prices. This leads bonds to carry varying degree of market risk for investors who do not wish to stay invested till their maturity dates. Similarly, bonds also carry credit risk or default risk — the possibility of the bond issuer defaulting on its future coupon or maturity repayments. Government bonds carry the lowest credit risk due to their sovereign backing. Within the corporate bond category, those with higher ratings, typically AAA to BBB, carry lower credit risk than others.
Fixed deposits do not have market risk as they are not traded on the stock exchanges. However, bank FDs carry credit risk due to the risk of bank failures. This risk has been reduced for the depositors through the deposit insurance program of the Deposit Insurance and Credit Guarantee Corporation (DICGC), an RBI subsidiary. This insurance program covers cumulative bank deposits of up to Rs 5 lakh held by each depositor of each schedule bank. The cumulative deposits include fixed deposits as well as the deposits maintained in savings account, recurring deposits and current account. Both interest and principal components of the qualifying deposits are insured under this program.
While corporate FDs do not carry market risk, they are prone to credit risk. Unlike FDs opened with scheduled banks, those investing with corporate FDs are not covered under the deposit insurance program of DICGC. Investors can reduce their credit risk by evaluating corporate bonds on the basis of credit ratings assigned by the credit rating agencies like CRISIL, CARE, ICRA, India Ratings, etc. Just as in the case of corporate bonds, corporate FDs having higher credit ratings carry lower credit risk and vice versa.
Liquidity
Listed bonds can be traded in the secondary markets, which allows their investors the opportunity to sell those bonds before their maturity dates and without incurring any prepayment penalty. However, some bonds may have very low liquidity due to their lower trading volumes in the secondary market.
Banks and NBFCs offer two types of FDs—callable and non-callable FDs. A callable FD allows its depositor to close the FD before its maturity date in lieu of a premature withdrawal penalty. In contrast, non-callable FDs do not allow premature withdrawal under any circumstances. Additionally, tax-saver fixed deposits come with a mandatory lock-in period of 5 years.
Also Check: Government Bonds
Tenure
The tenure of bank FDs usually ranges from 7 days to 10 years whereas the tenure of bonds can range from 1 year to 40 years. However, as bonds are traded in the stock exchanges, investors can purchase bonds from the secondary market for shorter tenures or for those matching their investment horizons. The availability of longer tenures in listed bonds also allows investors to lock in bonds at attractive yields for longer investment horizons.
Tax Deduction under Section 80C
Tax saving fixed deposits issued by banks and post office are eligible for deduction under Section 80C, up to a limit of Rs 1.5 lakh per financial year. While the principal amount qualifies for deduction, the interest component is taxed as per the depositor’s tax slab. However, bonds do not qualify for any tax deduction under Section 80C.
Taxation of Returns
The interest income earned from both FDs and bonds are taxable as per the tax slab of the investor. While FDs do not offer any scope for capital appreciation, any capital gains earned from bonds, both long term and short term capital gains, are taxable. In case of both listed bonds, capital gains booked after 1 year of investment are considered as long term capital gains and are taxed @ 12.5%. Capital gains booked within 1 year of investing in bonds are considered as short term capital gains and are taxed as per the tax slab of the investor.