Corporate Bonds V/S Fixed Deposits – An Investors’ Dilemma

The Need For Alpha Returns

Inflation – does the word ring any bells? In the post-Covid era, which witnessed a probable K-shaped recovery, many of us have been brutally hit by this problem. Be it food, energy, health, or education, the rise in prices has caused global mayhem, resulting in rising interest rates across the world. But how does inflation exactly affect us?

Let us dive a little into the concept of dosa economics introduced by Mr. Raghuram Rajan, the renowned ex-RBI governor. Suppose a person has INR 1 Lakh in his bank account today, which they invest in a fixed deposit yielding 6% return per annum, while the inflation is at 8%. Also, let us assume that the person consumes only dosas every day, and each dosa costs INR 60. Using this 1 lakh, the person will be able to buy 1666 dosas immediately. Or, they can wait till the end of the year, which is when each dosa will cost INR 64.8. The person’s total FD investment will be worth INR 1.06 Lakh at that point, and they will be able to buy 1635 dosas only!

This is how high inflation eats up the capital, thereby affecting future purchasing power. And how does one manage to beat inflation? By chasing higher returns on their capital. However, higher returns come with a pinch of salt, which is the looming risk associated with the instruments that generate them.

Fixed Deposits – A Generational Wealth Creator?

Fixed deposits,  (FDs), have been a traditional method of investment in our country for decades now. Since childhood, most of us have been encouraged to save and invest in FDs, because banks hardly pay any interest on our savings lying in their accounts. But do FDs benefit us in the long run? Before moving to any kind of conclusion, let us first understand what FDs are and how they work.

Fixed deposits (FDs) are a tool for investment provided by banks, post offices, and non-banking financial companies (NBFCs), which offer a certain percentage of fixed return over a specified period or tenure. All these entities generally use the money raised through these FDs to run their operations. It is almost like a loan that we give to these entities, however, we get the entire return and principal paid at maturity only. There are provisions to withdraw early too, which come with some kinds of penalties or charges generally.

Benefits Of Fixed Deposits

• Fixed maturity and returns, which enables investors to plan their future expenses better
• Low risk, especially when invested in FDs of renowned and well-established entities
• Can invest up to INR 1.5 Lakh in FDs with a lock-in period of 5 years to avail of tax exemption benefits under Section 80C
• The principal amount and accumulated interest on FDs and other savings in a commercial bank are insured up to INR 5 Lakhs by the DICGC¹. If someone has INR 2 Lakh in a savings account with a commercial bank, and an FD of INR 10 Lakh with the same bank, then the person’s entire investment is insured up to INR 5 Lakh in the event of banking failure 

Drawbacks Of Fixed Deposits

• Returns from FDs are hardly able to beat inflation in the long run
• No early liquidation without penalties or charges, hence the returns are even worse if the FD is withdrawn prematurely
• Fixed interest rates. Investors in long-dated FDs cannot just liquidate and move to high-interest FDs, they will have to pay some kinds of penalties and charges first

Corporate Bonds – A Low-Risk Investors’ Defense Against Inflation?

Just like FDs, corporate bonds are a tool for debt investment provided by corporations and banking/non-banking entities. Similarly, the capital raised through bonds is utilized by these entities to run their operation and/or do some kind of capital investment. Corporate bonds generally provide a higher rate of interest than FDs. Moreover, many of the bonds can even be liquidated in the secondary market, thereby providing the investors the option to take an early exit without incurring any kinds of penalties, and with minimal charges (mostly transactional and taxation).

Corporate bonds also provide the option to receive monthly/quarterly/annual coupon payments. This enables the investors to recover some part of the capital even before maturity, thereby reducing the risk involved.

Benefits Of Corporate Bonds

• Fixed maturity, but with the option to liquidate early in secondary markets
• Moderate to low risk, basis the kind of collateral and returns offered
• Providing a secondary source of income, through the provision to receive coupon payments regularly
• Collateral is involved in many cases, which helps the investor a large chunk of the invested principal in case the raising entity goes down under
• Returns from corporate bonds are generally able to beat inflation in the long run

Drawbacks Of Corporate Bonds

• Investors are spoilt for choices when it comes to investing in these instruments. It is very important to do a risk-return analysis in the case of corporate bonds
• Money invested in corporate bonds is not covered under any kind of insurance
• Some bonds being traded on an exchange might not be very liquid

Fixed Deposit v/s Corporate Bonds – A Quick Comparison

Conclusion

For someone seeking just capital preservation and not worried about beating inflation, fixed deposits certainly provide a good investment option. However, the investor must be wary of the fact that FDs are not very liquid in nature, and might harm their returns to a great extent if exited prematurely.

For most investors, based on their entire portfolio, it is important to have a proper mix of FDs and corporate bonds in their investment basket. Both instruments are generally devoid of the kinds of risks that are present in the equity markets. In case an entity issuing bonds gets liquidated, then their bondholders are given preference for payment over the shareholders. 

Just remember, every day that goes by without investing properly adds a certain percentage point in favour of inflation. So, go out, find a credible financial advisor, and get a comprehensive diversified portfolio designed for yourself! 

Or explore and invest in lucrative investment opportunities giving inflation-beating returns via Grip.

References:

1. Reserve Bank of India <https://tinyurl.com/3fne8phw>

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