Among the debt instruments that are popular among investors, other than mutual funds, you have bank FDs, corporate bonds and Government securities. How do these instruments rank on various parameters? Let us look at them parameter wise.
On the basis of returns
In terms of returns, corporate bonds give the highest returns as there is a corporate issuer risk involved. When it comes to corporate bonds, the returns on AA rated bonds are higher than on AAA rated bonds. Slightly below the returns on corporate bonds are the Bank FDs. Bank FDs are giving about 7.5% to 8% returns currently. They are almost as good as secured although in reality the coverage is only to the tune of Rs.1 lakh per account. Government securities issued by the central government have the lowest returns of a little over 7%. However, these will differ based on the existing rates in the economy. State government bonds can give slightly higher returns but they also come with higher levels of risk.
How they compare on default risk?
Government securities have zero default risk since central governments are not known to default on their commitments. While bank FDs are also virtually risk free, they are technically more risky than the government securities in terms of default risk. One needs to be cautious on FDs with non-scheduled banks as compared to scheduled commercial banks. Corporate bonds rank the highest in terms of default risk and the risk can go up much further if you go down the rating curve towards AA rated bonds and A rated bonds.
How these instruments compare on interest rate risk?
Interest rate risk is the risk of the bond prices reacting to changes in the interest rates. Bank FDs are the least vulnerable to the movements in the interest rates. Firstly, bank FDs do not have a ready secondary market and the returns are fixed through the tenure. There is a slightly higher risk of interest rate movements in corporate bonds but most corporate bonds are not too liquid. The biggest impact of the movements in interest rates are felt by government securities as they are highly liquid in the secondary markets and also their yields are most vulnerable to the shifts in yields in the market.
How they compare on liquidity?
Clearly, the government securities are the most liquid and corporate bonds are the least liquid. While most corporate bonds are traded in the secondary market, they are either price unfavourably or they entail a cost in terms of spreads. Bank FDs are not liquid in the sense that they do not have a ready secondary market. But bank FDs provide liquidity two ways. It is possible to liquidate FDs at a very small cost. Alternatively, it is also possible to take loans against these FDs with very minimal outflows in terms of cost. In terms of liquidity, G-Secs would rank highest followed by Bank FDs and finally by corporate bonds.
Understanding the tax treatment of these debt instruments
In taxation terms, the interest received on all the three is treated in the same manner. They are added to the total income of the holder and then they are taxed at the applicable peak rate. That is the standard treatment in all the three cases. But how are capital gains taxed. In case of government securities and corporate bonds these are debt instruments and holding period of above 3 years will be treated as long term capital gains. The tax will be levied at 20% on LTCG with benefit of indexation. STCG will be at the peak rate applicable to the individual. Since FDs are redeemed at par, there is no question of capital gains in bank FDs. There is also an aspect of tax exemptions available. There are no tax rebates or exemptions for investment in G-Secs or private corporate bonds. However, bank FDs with tenure of 5 years are classified as long term FDs and eligible for Section 80C exemption subject to lock in period of 5 years.
Investors can make their choice of the debt instruments after considering the pros and cons of the above instrument.
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