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

Introduction

Financial planning strives to combat inflation through adequate portfolio diversification that ensures a balance between risk and returns. Individuals and financial planners use different asset categories to achieve capital preservation and appreciation. Capital preservation refers to the protection of a financial corpus against the eroding effect of inflation.

Instruments like corporate bonds and fixed deposits are commonly known and used investment opportunities. Both of these assets are fixed-income-generating investment opportunities and help achieve a safe risk and return balance.

The blog critically compares FD vs bonds by comparing their returns, risks and much more. The objective is to help perform adequate risk assessment before investing.

What Are Fixed Deposits ?

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.

Advantages Of Fixed Deposits

• Fixed deposits earn a fixed return irrespective of market fluctuations.
• Investing in a fixed deposit is easy and less time-consuming.
• It is suitable for risk-averse investors.
• Fixed deposits can be made for short-term, long-term or medium-term.
• Fixed deposits are highly liquid. Investors can also use it as a mortgage to take loans.
• Senior citizens are given higher interest on fixed deposits.
• The principal and interest of a fixed deposit are insured up to INR 5 lakhs by DIGCC^1.

Disadvantages Of Fixed Deposits

1. Due to a very low risk and return ratio, the yield on FD is lower than most other asset classes. Therefore, the rate of return might be lower than the rate of inflation, resulting in a low capital preservation.
2. Investors have to pay a penalty in case of premature withdrawal from a fixed deposit.
3. The interest rates are rigid and do not change with a change in the market. Although it acts as an advantage when the market performs poorly, investors do not get high returns when the market performs well.

What Are Corporate Bonds ?

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.

Advantages Of Corporate Bonds

1. These are debt instruments which imply that if a company seizes its affairs, bondholders receive repayment priority over shareholders.
2. The ratings of corporate bonds help identify the risk and returns associated with different bonds. It enables convenient risk and yield comparison.
3. The return on corporate bonds is fixed. Therefore, even if the market fluctuates and performs poorly, corporate bonds continue to provide a fixed rate of return.
4. Although the maturity is fixed, investors can liquidate their investments by selling their bonds in the secondary market.
5. Corporate bond returns might be able to provide capital preservation in the long run.
6. Adequate risk assessment and optimum portfolio diversification using corporate bonds can help reduce risk because corporate bonds are often secured by collateral.

Disadvantages Of Corporate Bonds

1. Some corporate bonds are not secured by collateral. Such corporate bonds are riskier than secured bonds.
2. Bonds experience interest rate risk. This type of risk refers to the fall in the existing bond value when new bonds providing higher interest enter the market. In such a scenario, old bondholders will find reselling their bonds in the secondary market difficult.
3. Liquidating corporate bonds of small and medium-scale businesses in the secondary market might be difficult.
4. Unlike fixed deposits, corporate bonds are not insured.

Fixed Deposit v/s Corporate Bonds – A Quick Comparison

The table below shows a detailed comparison of fixed deposit vs bonds, particularly corporate bonds. It will help perform yield comparison and risk assessment. Thus ensuring capital appreciation through optimum planning.

Liquidity Comparison Of Corporate Bonds Vs FD

The table below compares the liquidity position of corporate bonds and fixed deposits.

Unlock Liquidity: Grip’s Seamless Bond Exit Option

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Factors To Consider Before Choosing Between Corporate Bonds vs FD

1. Risk and return: The most important consideration before undertaking any investment is the proportion of risk and return. When the return increases, the associated risk also increases. The opposite is true when the return falls. Although corporate bonds offer higher returns than fixed deposits, they are also riskier. Investors should adequately take into consideration their risk appetite. They should also perform yield comparison and risk assessment. The risk and return of an investment should match investors' risk appetite and return needs.

2. Investment goal: The objective of the investment must be set clearly. The objective, in turn, will help decide the characteristics an asset must have. For instance, if gold requires higher liquidity, an investor might be better off with corporate bonds because they can be liquidated in the secondary market without any penalty. However, if the security of investment is integral, for instance, in the case of medical emergency savings, a FD is the most secure investment avenue.

3. Nature of investor: The nature of the investor not only decides his risk appetite but also the asset class that suits his tendency. For instance, a young risk-averse investor might choose an FD over corporate bonds, though he is capable of bearing the extra risk associated with bonds.

4. Tenure: The tenure of investment decides the suitability of the investment avenue. Fixed deposits provide very little return in the short term. Therefore, if an investor wishes to earn a return over a small period of time FDs might not be able to generate enough returns.

5. Current market conditions: The characteristic feature of an asset is not enough to determine its profitability. The success of an investment depends upon the prevalent market conditions. For instance, regardless of the attractive features of a corporate bond, if the bond market is performing poorly, an investor will not be able to generate enough returns. However, market fluctuations stabilise in the long term. Therefore, market consideration should be made along with tenure consideration. 

6. Interest rate risk: When the market rate of interest increases, the value of existing bonds decreases because they are no longer attractive to buyers due to their low interest rate. Therefore, optimum portfolio diversification across various investment avenues is necessary to cushion against interest rate risk.

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.

Fixed deposits and corporate bonds cover different aspects of successful investment while maintaining certain similarities. Investors must compare each investment module to gauge what suits them best. A thorough understanding of FD vs Bonds is essential for optimum portfolio diversification. Not just FD Bond interest rate consideration, proper risk assessment is necessary for optimum financial planning.

Frequently Asked Questions On Corporate Bonds Vs FD

1. Are corporate bonds safer than fixed deposits?

Every investment category has its advantages and disadvantages. While FDs are the most traditional and commonly considered secure, they have their own drawbacks. It is necessary for investors to compare different investment options available to them and choose the one that suits their investment objectives.

2. Can I liquidate corporate bonds before maturity?

Corporate bonds cannot be directly liquidated before maturity. However, corporate bonds can be sold in the secondary market and thus liquidated. It is necessary to time the secondary sale of corporate bonds properly due to interest rate risk, This risk implies that when market interest increases, the value of existing bonds falls.

3. What are the key differences between FD and Corporate Bonds?

Both fixed deposits and bonds are fixed-income generating assets. However, FDs provide lower returns than corporate bonds. Moreover, withdrawals from FDs attract penalties, while corporate bonds can be traded in the secondary market. Moreover, unlike bonds, FDs don’t have any collateral, but they carry insurance of up to INR 5,00,000.

4. How does the credit rating of a corporate bond affect its risk and return?

Corporate bonds are rated instruments. Credit ratings are grades like A, AA, B, etc, assigned to an investment instrument by rating agencies depending upon their profitability and security. Bonds with better risk and return ratios are graded higher than those that carry exorbitant risks. It simplifies the task of investors by concising heavy fiscal data.

References: 

1. https://www.rbi.org.in/commonman/english/Scripts/FAQs.aspx?Id=272

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