Bonds vs FDs Which one is better for your investment portfolio

Over the years, you would have observed your parents investing in bank or post-office fixed deposits (FDs) to park their savings. For decades, until the 2000s, FDs were the popular kids in the investment class. The reason? Well, there are two: i) FDs used to satisfy the need of investors with stable returns, and it was convenient ii) there was a lack of awareness to choose any other investment options like bonds even as they fall under the same category of fixed-income instruments.

However, the time has changed, and FDs or post office deposits no longer provide inflation-beating returns. In such times, it is crucial for you to move on from FDs and explore other options, such as bonds. Bonds are similar to FDs in a way that they add stability to your portfolio, but if we compare, bonds are far better compared to FDs. How? Well, let’s find out after clearing some basics.

What Are Bonds?

Bonds are a versatile fixed-income instrument that allows investors to lend money to issuers such as governments, municipalities, or corporations in exchange for periodic interest payments and the return of principal at maturity. What makes bonds particularly attractive is their wide range of issuers and types, from highly secure government bonds to corporate bonds with varying credit risks and returns. Many bonds are backed by physical assets, which can provide additional security to investors. Another important aspect of bonds is their tradability; unlike fixed deposits, bonds can often be bought and sold in secondary markets, offering liquidity and the potential for capital gains if market conditions are favourable.

Moreover, bonds come with diverse features such as fixed or floating interest rates, different tenures ranging from a few months to several decades, and various tax implications depending on the bond type. For example, some government-issued bonds offer tax-free interest income, while others may provide tax-saving benefits under specific sections of the Income Tax Act. Understanding these nuances can help investors tailor their bond investments to suit their risk tolerance, income needs, and tax planning strategies, making bonds a flexible and potentially rewarding addition to any investment portfolio.

What are The Features of Bonds?

Bonds are a popular fixed-income investment option that comes with several distinct features, making them attractive to a wide range of investors. Here’s a quick look at what defines bonds:

Issuer Variety: Bonds are issued by governments, public sector units, municipalities, and private companies. This variety offers different risk and return profiles.
Fixed or Floating Interest: Most bonds pay a fixed interest rate (coupon) periodically, but some have floating rates linked to benchmarks.
Tenure: Bonds come with varying maturities, ranging from short-term (a few months) to long-term (up to 40 years or more).
Tradability: Unlike fixed deposits, bonds can be bought and sold in the secondary market, providing liquidity before maturity.
Credit Ratings: Agencies rate bonds based on the issuer’s creditworthiness, helping investors assess risk.
Capital Protection: Many bonds are backed by physical assets or government guarantees, offering the safety of principal.
Tax Treatment: Some bonds offer tax benefits, such as tax-free interest or deductions on investment.
Potential for Capital Gains: If interest rates fall, bond prices rise, allowing investors to earn capital gains if sold before maturity.

These features make bonds a flexible and valuable addition to any investment portfolio.

What are The Benefits of Bonds?

Investing in bonds offers several advantages that can complement your financial goals and portfolio strategy. Here are some key benefits:

Steady Income: Bonds provide regular interest payments, making them ideal for investors seeking predictable cash flow.
Higher Returns than FDs: Generally, bonds offer better interest rates compared to fixed deposits, enhancing your earning potential.
Diversification: Bonds help balance risk in your portfolio by offsetting the volatility of equities.
Tax Efficiency: Certain bonds, like tax-free and tax-saving bonds, provide tax exemptions or deductions, helping reduce your overall tax burden.
Liquidity: Bonds traded on stock exchanges can be sold before maturity, giving you access to funds when needed.
Capital Preservation: Government and high-rated bonds are relatively safe, protecting your principal investment.
Inflation Protection: Some bonds, such as inflation-indexed bonds, help protect your investment from inflation’s eroding effects.
Flexibility: With a wide range of issuers, tenures, and types, bonds can be tailored to fit different investment horizons and risk appetites.

Overall, bonds offer a blend of income, safety, and growth potential, making them a smart choice for both conservative and balanced investors.

What are Fixed Deposits?

A fixed deposit is a deposited amount in public/private banks, NBFCs, or post offices. You earn interest on your investment term and receive the principal + interest amount of maturity. FDs are considered a safe investment option, but they are not backed by physical assets like bonds.

In comparison, bonds provide higher returns than FDs. However, bonds are also considered risky compared to FDs. The average return on bonds ranges from 7% to 9%, while for FDs, it is around 5% to 6.50%. The question is, why should you tilt towards bonds over FDs?

What are the Features of Fixed Deposits?

Fixed Deposits (FDs) are among the most popular investment options, especially for those who prefer safety and guaranteed returns. Here are some key features that make FDs appealing:

Fixed Interest Rate: When you invest in an FD, the interest rate is fixed for the entire tenure. This means you know exactly how much you will earn, providing certainty and peace of mind.
Flexible Tenure: FDs offer various tenure options, typically 7 days to 10 years. This flexibility allows you to choose a term that aligns with your financial goals and liquidity needs.
Safety: FDs are considered very safe investments, especially with banks. Additionally, deposits up to ₹5 Lakh are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC), adding an extra layer of security.
Interest Payment Options: You can choose to receive interest monthly, quarterly, annually, or at maturity, depending on your cash flow requirements.
Premature Withdrawal: While FDs encourage you to lock in your money, most banks allow premature withdrawal with some penalty, offering a degree of liquidity.
No Market Risk: Unlike stocks or bonds, FDs are unaffected by market fluctuations, making them ideal for risk-averse investors.
Taxation: Interest earned on FDs is taxable as per your income tax slab, and banks deduct TDS if interest exceeds ₹40,000 annually.

These features make FDs a reliable and simple choice for many investors looking for capital preservation and steady income.

What are the Benefits of Fixed Deposits?

Fixed Deposits offer several benefits, making them a preferred choice for conservative investors and those seeking predictable returns. Here’s why FDs can be a valuable part of your investment portfolio:

Guaranteed Returns: One of the biggest advantages of FDs is the assurance of fixed returns. You know how much interest you will earn upfront, which helps in effective financial planning.
Capital Protection: Your principal amount is safe and secure, especially when invested in reputed banks or post offices. This makes FDs ideal for preserving capital.
Easy to Understand: FDs are simple and transparent investment products. You don’t need to worry about market volatility or complex terms.
Flexible Investment Amount: You can start investing in FDs with relatively small amounts, making them accessible to a wide range of investors.
Income Regularity: With options for periodic interest payouts, FDs can serve as a steady income source, especially for retirees or those needing regular cash flow.
Loan Against FD: Many banks offer loans against your fixed deposit, providing liquidity without breaking the FD.
Safe for Short to Medium Term: FDs are suitable for parking funds for short to medium durations, such as saving for a vacation, education, or emergency fund.
Wide Availability: FDs are offered by banks, NBFCs, and post offices, making them easy to open and manage.

Fixed deposits combine safety, ease, and predictable income, making them an excellent option for investors who want to minimise risk while earning steady returns.

Comparison Between Bonds Vs Fixed Deposits

The main reason that investors used to invest in FD in earlier times was that they thought it was the only safe haven as they didn't understand bonds. However, the time has changed and when we compare bonds with FDs, they are not only safe options but also superior in many ways.

Return on FDs vs Bonds

FDs and bonds both provide fixed interest returns for the tenure of investment. However, unlike FDs, you also get capital gains by investing in bonds as the price of bonds increases over a period of time.

Additionally, since the ’80s and ’90s, interest rates on FDs have been on a constant decline; this is not the case with bonds. If you see the current rates, the interest on FDs is hardly 5% to 6%, against 11% to 13% in the 80s and ’90s. In comparison, bonds, depending on the categories, have provided an average return of 8% to 11%. Not to forget that, along with this fixed interest, you also receive appreciation in the prices of bonds with time.

Taxation on FDs vs Bonds

The interest income you earn on fixed deposits is added to your income tax slab. If interest income goes above Rs. 40,000 for a financial year, you need to pay 10% TDS if you procure a PAN card. Otherwise, it is 20%. This can be daunting as FD returns are already lower, and higher taxes can lead to you not gaining any real gains.

While you also pay taxes with bonds, they are much more efficient. The interest earned on bonds is as per your tax bracket, but not the capital gains. The capital gains can be short and long-term based on which type of bonds you invest in, their duration, and where you sell them. STCG is applicable as per the tax slab, and LTCG for listed and unlisted bonds are 10% and 20%, respectively.

Also, unlike FDs, where you only have the option of tax-free FDs, there are a variety of bonds that offer you avenues to reduce your tax liabilities. For example, tax-free bonds, tax-saving bonds, government-issued infrastructure bonds, sovereign gold bonds, 54EC bonds, etc. If you plan your bond investment well, you can get tax deductions and tax-free income as well (depending on the bond category).

Lock-in Period of the Interest Rate for FDs vs Bonds

With fixed deposits, you can lock in your interest return for a maximum of 7 to 10 years. Additionally, the interest reduces as the tenure of investment increases. Compared to that, bonds offer you to lock in your interest rate for a much extended period of up to 40 years. There are also some instances of 100-year bonds. Bonds are much more flexible; you can invest from a 1-month to literally years and can lock in interest rates. This is not the case with FDs, as the most efficient tenure for maximum return is 5 years.

This feature of bonds proves to be a boon during the time of reducing interest rates by the central bank. FD rates tend to reduce during this period. In contrast, long-term bond yield (interest rate) becomes more attractive. Also, there is no reinvestment risk for bonds like there exists for FDs.

Conclusion

For investments, it is crucial to find the perfect option to ensure that your money is not decaying with time. Bonds and FDs both have their own advantages. However, in terms of return, tax efficiency, and flexibility to lock in interest rates, bonds outgrow FDs.