Bonds Versus Fixed Deposits

Bonds and Fixed Deposits (FD's) are widely considered the two most popular alternatives for risk-averse investors across the world. While both bonds and FD's are 'fixed income' instruments in the sense that they offer interest income to investors, they actually differ markedly across various parameters. It's worthwhile to educate yourself on the nuances of bond and fixed deposit investing in order to make an informed investment decision.

What Are Fixed Deposits?
Fixed deposits are financial instruments issued by banks, NBFC's (Non-Banking Financial Companies), as well as regular corporate entities. Fixed Deposits, as their name suggests, as 'fixed' for a particular duration, during which time the investor enjoys periodic interest payouts. Payouts can be monthly, quarterly, annually or cumulative in nature. Fixed Deposits differ from bonds in five major aspects. These are described below.

Safety
You'll find that most Bonds are secured in nature, as they are backed by physical assets. However, if the credit rating of the issuing entity deteriorates, the bond holder may not receive timely interest and principal payouts - therefore, it is advisable to check for credit ratings and stick to AAA, AA or A rated bonds only. Upon the unlikely event that a company goes bankrupt and its assets get liquidated, it is actually the bond holders who stand first in the pecking order.
FD's, on the other hand, are unsecured and not backed by assets. You may be surprised to discover that even Bank FD's are insured only up to Rs. 100,000 (capital and interest) per depositor. There is however, a very slim chance that Bank FD investors will lose money - a case in point is Global Trust Bank which, embroiled in the stock market scam of 2001, went under in 2004. While shareholders booked massive losses, deposit investors didn't lose a cent.

Liquidity
Bonds are tradeable on exchanges and can therefore said to be more liquid. However, remember that interest rate movements can impact bond prices (especially longer term bonds), and so the liquidity comes at the cost of price volatility. Fixed Deposits, on the other hand, can be withdrawn prematurely - although they aren't traded on the exchange. The premature withdrawals come at the cost of reduced interest.

Returns
Both Bonds and FD's offer a fixed payout at predefined periodicities (unless the bond in question is a zero coupon one which is issued at a discount to its face value and matures at its face value). However, Bonds offer the additional scope of earning Capital Gains, as Bond prices fluctuate either based on changes in market interest rates, changes in the creditworthiness of the issuer, or both. FD's are not tradeable on an exchange, and hence don't offer the scope of earning capital gains. It's worth noting, however, that bond trading isn't everyone's cup of tea, and an uninstructed retail investor will be taking a big risk by aiming to trade in bonds without an adequate degree of familiarity with the brass tacks of the debt market.

Credit Rating
It is a mandate for Bond Issuers to get their instrument rated by at least one rating agency such us CARE, ICRA or CRISIL. Issuers are strict about disclosure requirements and will typically not offer a rating without adequate information about the company that the general public are not privy to. For FD's those issued by NBFC's must mandatorily be rated; there's no such mandate levied on Bank FD's though. Ratings are useful as they allow greenhorn bond investors to easily evaluate the returns on offer in light of the risk they are taking on in the process.

Taxation
Interest from Bonds as well as FD's are subject to income tax as per the tax slab of the individual (taxed "at the margin"). However, there are tax free bonds issued by the government, on whose interest no income tax is payable. Examples of some upcoming tax free bonds include PFC, REC, NTPC, IREDA, HUDCO, IRFC and NHAI. The NHAI issue is expected to be sizable (at ~ Rs. 24,000 Crores). In case you choose to sell your bonds on an exchange prior to maturity, capital gains will apply.