Bonds versus FDs versus debt mutual funds: Which fixed-income option to choose?

Most Indians have traditionally invested a bulk of their savings in bank fixed deposits when it comes to choosing financial instruments while gold and real estate remain the favourite physical assets to own.

But rising awareness about investing and asset allocation as well as growth in financial and capital markets have opened up new investment avenues for people.

For investors who don’t want to deploy all or at least some of their money in risky assets such as stocks and equity mutual funds, there are various fixed-income instruments to choose from that keep their principal safe and steadily growth their wealth, too. In fixed-income instruments, the rate of return is usually fixed at the outset but there is still variation in some cases.

The three most common options for fixed-income investors are bonds, fixed deposits and debt mutual funds. Bonds and fixed deposits are money given to any entity or bank at a particular interest rate and returned after maturity. Debt mutual funds are also similar except in this case the money is given to an MF scheme which then invests it into different bonds. Let us look at each of them in detail.

Bonds 

Many entities in India issue bonds, including governments, both states and the Centre, municipalities, and corporates. While some bonds are issued on a private placement basis, that is, directly to a set of investors, others are through public issue, meaning anyone can invest in them.

While government bonds, the Reserve Bank of India has launched Retail Direct platform where anyone can go and buy gilts, for corporate bonds retail investment can be made only in case of a public issue or through the secondary market.

All issuers of bonds pay interest on the invested money, at a set period--quarterly or half yearly or annually. This return on investment is termed yield or coupon, depending on at which stage the bonds have been bought. If the bonds were bought at issue, then the return is referred to as coupon, while in case of a reissue of bonds or secondary market purchases when the bond is bought at a discount or premium to the face value, the return will be referred as yield.

Government bonds are considered to be the safest investment, but typically fetch lesser return than corporate bonds. The riskier the issuer, the higher is rate of return.

Most of the investors in bonds are big banks, insurance companies, pension and provident funds, mutal funds and other financial institutions that can invest large sums of money and can manage the complexities of investing in these instruments.

Taxation on bonds is similar to that of fixed deposits. The income gets added to total income of the investor and taxed according to applicable slab.

Advantages of bonds

Stability – The investors get their assured return set at the outset.
Security – Many bonds issued by companies are secured against some kind of assets, providing assurance of return.

Disadvantages of bonds

Inflation – If inflation runs high it can eat into the return from bonds as the interest rates are usually fixed.
Low liquidity - The secondary corporate bonds market is not deep in India, meaning it may not be easy to sell such securities easily. However, this is not true for government bonds that have high secondary market activity.

Debt Mutual Funds

To reduce the risk of lending to a single company or project and earn higher income, people invest in debt mutual funds.

These funds pool money from individual investors under a scheme and then invest them in bonds as per the stated aim of the scheme. Some mutual fund schemes invest only in bonds issued by the government, some in corporate bonds and some in a mix of both.

Because mutual funds schemes are run by professionals, it is expected that they will better manage the risk of investing in bonds while ensuring higher returns. Performance of each mutual fund scheme varies.

The Union Budget for 2023-24 has brought taxation on debt mutual funds at par with fixed deposits---the interest earned gets added to the income of investor and taxed accordingly.

Earlier, the returns were taxed based on how long the units were held. If the holding period of mutual fund units was less than 36 months, short-term capital gains tax was imposed. But if investors held mutual fund units for more than 36 months, then they had to pay long term capital gains tax of 20 percent. The investors were also allowed an indexation benefit. Indexation benefit means the gains made by investors were adjusted for inflation. This lowered tax even further.

Advantages of debt MFs

Risk spread -  As MF schemes invest in many bonds, the risk gets spread across a spectrum of assets
Professional help – These funds are managed by people who are experienced in assessing risk better than individual investors
Liquidity – Most debt MF will allow investor to cash out at current net asset value after the lock-in period.

Disadvantages of debt MFs

Fee – Debt MF managers will charge a fee for managing the fund.
Control – Only managers can decide where your money is invested.

Fixed deposits

Fixed deposit is one of the most popular modes of investment in India. Both households and companies invest in fixed deposits. While in case of households, fixed deposit is mostly a medium to park long-term savings, for businesses it is a source for earning some return from their excess cash flow.

Banks, deposit-taking non-bank financial companies and companies use the money garnered through fixed deposits to give loans to others or invest in their business. Similarly, the government uses fixed deposits of post offices for its expenditure.

It is important to know how fixed deposits with different entities are used by them. This will inform investors how safe their money is. A common principle: Safer the investment, lower will be the returns or interest earnings. 

Private companies offer higher interest than banks on deposits because of involvement of risks in their business. 

Advantages of fixed deposits

Assured return: As the interest rate on fixed deposits is agreed upon at the start of the investment cycle, investors are assured of safe income.

Tax sops: Senior citizens can claim a tax deduction of up to Rs 50,000 on interest earned from fixed deposits. Also, a person can claim fixed-deposits of over five years as deduction under Section 80 C of the Income Tax Act.

Safe Investment: Although no investment is 100% safe, fixed deposits, especially with banks and reputated NBFCs, come closest to being counted as one.

Security: Fixed deposits can be used as security to take loans.

Liquidity: A person can withdraw fixed deposit prematurely, except the five-year tax saving ones, in case of emergency. However, the bank may adjust the rate of return in the case.

Disadvantages of fixed deposits

Locked interest rates: Interest rates on fixed deposits are set at the start of the term. In case, interest rates in the banking system rises, the investor will miss out on earning higher return. Conversely, this will be of advantage in case the interest rates fall.

Penalty on early withdrawal: Some penalty may be levelled on withdrawal of fixed deposits before maturity.

Shorter Maturity: Banks normally do not offer fixed deposits for more than 5 years. So if your looking to lock in a higher interest rate for a longer period, bonds may be a better option.

Differences between bonds, fixed deposits and debt mutual funds

Security – All the three—bonds, fixed deposits and debt mutual funds—are considered more secure than most other investments. However, if one were to look closely, government bonds, and fixed deposits may be considered the safest options.

Return – Usually corporate bonds will give the most returns, followed by debt MFs. Gilts and fixed deposits will mostly give lowest returns. But these principles are fluid and keep changing according to interest rate in the banking system.

Secondary market – While fixed deposits can’t be sold, bonds have a secondary market and debt MFs can be redeemed.

Control – In bonds and fixed deposits, investors have direct control over the flow of money, but in case debt MFs the control, within the limits of the scheme, is with the fund managers.

Conclusion 

Bonds, fixed deposits and debt mutual funds are all fixed income instruments with a varying degree of risk and return depending on their issuers. They are generally safer than equity investments, but nothing is guaranteed.

Now that income tax has been mostly been levelled on all these securities, it is the risk-and-reward ratio that should decide your investment decisions.