Bonds vs FDs! What should investors choose?

The answer to this conundrum lies in the resurgent bond markets. Moderation in inflation, healthy onset of monsoon, resilient domestic currency and a series of interest rate cuts has set the bond prices soaring. Effectively, 10-year benchmark sovereign bond yields have moved substantially lower.

Jun 25, 2015 03:06 IST IIFL Hitesh Jain |

An investor always seems to be in a dilemma as far as parking a proportion of savings is concerned. With interest rates on fixed deposits yielding around 8-9%, the hunt is always on for better fixed income alternatives. The answer to this conundrum lies in the resurgent bond markets. Moderation in inflation, healthy onset of monsoon, resilient domestic currency and a series of interest rate cuts have set the bond prices soaring. Effectively, 10-year benchmark sovereign bond yields have moved substantially lower.
 
In light of such a backdrop, the bond markets seem alluring, with several corporate raising capital through non-convertible debentures at much attractive interest rates for the investors. Volatility in the broader markets makes it compelling to scout for avenues, which provides capital protection. However, the food for thought is how different are bonds from fixed deposits. It is imperative to compare the merits and demerits between bonds and fixed deposits.
 
There are several parameters, which can throw light on the differentiation. We adumbrate the same:
 
Capital Appreciation: Bond prices are inversely correlated with the sovereign yields, implying that bond prices go up when interest rates go down. The trajectory of the bond market is predominantly influenced by the interest rate trajectory. With the monetary policy of India being data driven, there is scope for monetary easing if the macroeconomic situation permits the same. The next rate cut is primarily dependent on the progress of monsoon and its effects on inflation. In fact, the RBI governor’s comment that the monsoon has been ‘quite strong’ has rekindled hopes of a rate cut sooner than earlier anticipated. Better onset of monsoon and positive government action can pave the path for further reduction in interest rates. In addition, there is a wide expectation that the government will contain food inflation through effective food management policies. Fiscal consolidation, improving economic growth and containment of inflation should ensure additional rate cuts to the tune of 50-75 basis points by the end of this fiscal year. Effectively, there is a great upside potential for the bond prices. However, FDs are deprived of any capital appreciation.
 
Tax benefits: Investments in NCDs spanning more than one-year period falls into long term capital gains tax category, while returns on FDs do not enjoy this privilege. In addition, Tax free bonds (issued by government institutions) score much better than Bank FDs, when the yields on tax free bonds are compared with the post-tax returns on the latter. For instance, an investor (belonging to 30% tax bracket) fetches annualised return of 7.5% on tax free bond, while a FD may offer 8.5%. However, back of the envelope calculations reveals a post-tax return of around 5.9% on the FD, literally 160 basis points lower than the yield on the tax free bond.
 
Instrument Pre-Tax return Post-Tax return
Tax Free Bond 9.75% (implied) 7.5%
Fixed Deposits 8.5% 5.9%
 
Also, tax is deducted at source when Banks pay more than Rs10,000 as interest payment in  a year. On the other hand, listed NCDs in the demat form attract no TDS.
 
Security: Non convertible debentures (NCDs) can be secured and unsecured as well. Secured NCDs provide the investor claim on the assets of the company, if it fails to meet the debt obligations. In case of a default by commercial Banks on its FD, Reserve Bank of India insures the sum only up to Rs. 1 lakh (including the principal and interest). Corporate Fixed deposits are unsecured, which therefore entails higher risk.
 
Exit: NCDs are traded on the exchange. This enables them to be transferred and permits exit before the maturity date. However, premature withdrawal from FDs attract penalty and also implies lower returns than the amount one would have received if held till maturity.
 
Credit Rating: All NCDs are rated by credit agencies, while corporate fixed deposits issued only by NBFCs hold credit rating.
 
Considering these factors, NCDs clearly have an upper hand over FDs. Although there may not be wide differentials in respect with interest rates on taxable NCDs and FDs, the risk/reward ratio is inclined towards the former. Investments in Bonds/NCDs should form an essential part of fixed income portfolio, particularly if one is looking at short-medium term horizon.

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