Fixed Deposit vs Bond vs Debt Mutual Funds: Which is Better?

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.

Feature	Fixed Deposits	Bonds	Debt Mutual Funds
Definition	A financial instrument provided by banks or NBFCs that offers investors a higher rate of interest on the deposited amount than a regular savings account, until the given maturity date	Debt instruments in which an investor loans money to a governmental or corporate entity, which borrows the funds for a defined period at a fixed interest rate	Investment funds that pool money from various investors to invest in fixed-income securities like bonds, treasury bills, government securities, etc.
Risk	Low risk as they are mostly insured and offer a guaranteed return	Varies from low to high depending on the issuer’s credit rating; government bonds are generally low-risk, while corporate bonds can carry higher risk	Moderate risk, arising from interest rate risk and credit risk of the underlying securities
Returns	Fixed and predetermined, not influenced by market fluctuations	Fixed or variable returns depending on the type of bonds; generally, offer higher returns than FDs	Variable returns that depend on the market performance of the underlying securities; generally higher than FDs, but lower than equity funds
Liquidity	Lower liquidity as money is locked in for a pre-defined term and premature withdrawal often results in penalties	Relatively liquid, especially if the bonds are traded on exchanges (but liquidity depends on the market demand)	Generally more liquid than FDs and bonds, because the units can be redeemed at any time, though exit load may be applicable
Tax Treatment	Interest earned is taxable as per the individual’s tax slab	Interest earned is taxable as per the individual’s tax slab (except in the case of tax-free bonds)	Capital gains are added to the investors’ income and taxed as per the applicable slab rate (for investments made on or after April 1, 2023)

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.

FAQs

Who should invest in debt mutual funds?

Debt funds are suitable for risk-averse investors seeking stable returns, especially in the short run. Overall, debt funds are ideal for capital preservation and can thus act as an emergency fund.

Who should invest in fixed deposits?

Fixed deposits are ideal for those who prioritise security and predictability over potential higher returns. Moreover, in the case of fixed deposits with high exit loads, the investor should be financially stable enough to not withdraw that FD amount for a few years.

What are the different types of debt funds?

There are various types of debt funds such as bond funds, money market funds, liquid funds, etc. They usually differ based on the timelines of investment and the types of instruments they invest in.