Which Fixed-Income Alternative Is Better: FDs versus Bonds versus Debt Mutual Funds?

With equity investments becoming popular among investors from various demographics, the Indian equity market is witnessing rising retail investor participation. However, equity stocks and mutual funds are best suited for investors with a high tolerance for risk. For more conservative investors, low-risk fixed-income investments make for better alternatives. That said, these fixed-income options are essential even for aggressive investors because they reduce the overall portfolio risk. 

So, if you are considering investing in fixed-income investment options, you may find yourself facing various choices like fixed deposits, bonds and debt funds. Which of these is better for your portfolio? Let’s find out.

Fixed Deposits 

Fixed deposits are one of the most popular traditional fixed-income investment options in India. Here, you invest a fixed sum of money in an FD account with a bank or non-banking financial company (NBFC). The amount is deposited for a fixed tenure ranging from 7 days to 10 years or more. Over this period, you earn interest on the deposited amount at a predetermined rate of interest. 

This interest can either be reinvested in the deposit account (as in the case of cumulative FDs) or paid out to you periodically (as in the case of non-cumulative FDs). At the end of the investment tenure, you can withdraw the capital invested along with accumulated interest, if any. 

Pros of Fixed Deposits

• Guaranteed returns at fixed interest rates
• Safe with minimal risk to the principal 
• Easy to open and manage
• Option to borrow against the deposit
• Can provide regular income through interest
• Often insured up to a certain amount

Cons of Fixed Deposits

• Potential erosion of value due to inflation
• Financial penalties for early withdrawal
• Interest earned subject to taxation
• Limited in terms of long-term wealth growth

Bonds

Bonds are debt instruments that are issued by government and other corporate entities to raise funds for various purposes. The capital used by investors to purchase these bonds are considered as loans offered to the issuing entity. As a result, the issuing entity offers fixed income in the form of interest on the bond value at a predetermined interest rate (known as the coupon rate). 

Government bonds are generally considered low-risk since they are backed by the government’s sovereign guarantee. Corporate bonds carry a higher risk but often offer higher yields to compensate for this increased risk. Bonds can be traded on the secondary market, offering liquidity to investors who wish to sell their bonds before maturity. 

Pros of Bonds

• Regular and predictable income from interest payments
• Potential for higher returns than fixed deposits
• Diversification of investment portfolio
• Lower risk compared to stocks
• Can be sold in secondary markets for liquidity
• Variety of options including government, municipal and corporate bonds

Cons of Bonds

• Interest rate risk that could affect bond prices
• Credit risk, especially with corporate bonds
• Lower returns compared to stocks over the long term
• Potential erosion of real returns due to inflation 

Debt Mutual Funds 

Debt mutual funds are investment options that pool money from various investors to invest primarily in fixed-income securities like bonds, treasury bills, government securities and corporate debentures. Unlike equity mutual funds, which invest in stocks, debt funds follow a more conservative investment strategy and focus on generating income while preserving capital.

These funds are managed by professional fund managers who allocate assets across various debt instruments, depending on the fund’s investment objective and market conditions. The returns, however, are not fixed and vary depending on the market performance of the underlying securities. 

Read More About What is Debt Mutual Funds?

Pros of Debt Funds

• Potential for higher returns than fixed deposits
• Professional fund management
• Diversification across various debt instruments
• Liquidity for easy entry and exit
• Suitable for short-term  to medium-term investment horizons
• Lower risk compared to equity funds

Cons of Debt Funds

• Subject to interest rate risk and credit rate risk 
• Returns not guaranteed and can fluctuate
• Requires understanding of debt market dynamics
• Exit load may be applicable for early withdrawals

At a Glance: Fixed Deposits vs. Bonds vs. Debt Mutual Funds

Let’s examine and summarise the key differences between fixed deposits, bonds and debt funds at a glance. 

Also Read More About Mutual Fund vs Fixed Deposit

FDs vs. Bonds vs. Debt Mutual Funds: Which Should You Choose?

The choice of fixed-income investment depends on your individual investor profile and financial requirements. Broadly, the following pointers can help. 

Fixed deposits may be suitable for you if:

• You want a stable and predictable income without exposure to market risks
• You seek to preserve your principal amount and are not willing to risk your capital
• You have a short-term or medium-term financial goal 
• Your income falls in a lower tax bracket

Bonds may be suitable for you if:

• You are looking for regular income (through interest payments) 
• You are comfortable with a slightly higher risk than FDs for potentially better returns
• You are seeking to diversify your investment portfolio beyond stocks and FDs
• You are comfortable with locking in your money for a longer duration

Debt mutual funds may be suitable for you if:

• You are willing to take on some market-linked risks
• You need the flexibility of withdrawing your investment without significant penalties
• You are comfortable with a moderate level of interest rate risk and credit risk 
• You prefer having professional fund managers actively manage your investment

Conclusion

Fixed deposits (FDs), bonds and debt mutual funds each caters to different investor profiles and objectives. While choosing the right investment, it’s essential to understand that you do not have to be exclusive. You may benefit from diversifying your portfolio and investing in a combination of these options to balance risk and returns.

For instance, if you seek capital preservation and regular income, you may prefer fixed deposits. However, you could also allocate a part of your assets to debt mutual funds for potentially higher returns and liquidity. Similarly, bonds can complement these choices by offering a middle ground with regular income and the potential for higher yields, particularly through government or high-quality corporate bonds.

Ultimately, the best approach is to align your investments with your financial objectives, time horizon and risk appetite — and remember that combining different types of fixed-income investments can create a more dynamic and well-rounded investment portfolio.

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