Beyond fixed deposits: Are bonds a better bet for investors seeking higher returns, tax efficiency?

Should I invest in bank fixed deposits or bond funds for the debt portion of my portfolio? I want to know which is better for returns, safety, and taxes, given my moderate risk appetite.

Every investment decision demands trade-offs. Should you chase higher returns, accepting the possibility of losses, or settle for lower but safer gains? One of the most common dilemmas for investors is whether to allocate their debt portfolio towards bank fixed deposits (FDs) or bond funds.

Advice by Akhil Rathi, Head – Financial Advisory at 1 Finance

India offers a vast array of investment options, many promising good returns. Faced with this abundance, it’s natural for investors to feel uncertain about where to invest. There’s no single “best” option—it all depends on individual goals and risk appetite. However, Indians often gravitate toward government-backed instruments for their perceived safety and reliability.

Bond funds, whether they invest solely in government securities or include corporate bonds, carry market-linked risks. Their value fluctuates because investors buy and sell units at the fund’s net asset value (NAV), which is driven by the market prices of the underlying bonds. Bond prices and interest rates move inversely: bond values climb when interest rates fall, and decline when rates rise.

Choosing between bank FDs and debt mutual funds should start with defining your investment goals. If you’re investing for emergencies or short-term needs, prioritise safety and liquidity over returns. For such cases, savings accounts, sweep-in FDs, and liquid or ultra-short-term debt funds work well, offering quick access and minimal risk.

However, for medium- to long-term goals, debt mutual funds—particularly those in the short-duration or dynamic bond categories—can be more rewarding. These funds diversify across government securities, corporate bonds, and other debt instruments, managing both credit risk and interest rate volatility. Over time, they often outperform FDs, especially when interest rates are falling.

Taxation also plays a key role in the decision. Interest earned on FDs is taxed annually on an accrual basis at your income tax slab, even if you haven’t withdrawn it. In contrast, debt fund gains are taxed only upon redemption, allowing you to defer tax liabilities and potentially reduce your overall tax outgo.

If your debt investments are meant to provide stability—and you’re comfortable with some NAV fluctuations—debt mutual funds, especially high-quality short-duration or dynamic funds, can be a tax-efficient option over the long run. Aligning your investment mix with your risk tolerance, liquidity needs, and time horizon is crucial for the best outcomes.

Bonds, meanwhile, offer a compelling alternative for those looking to earn more than what traditional FDs provide. One major draw is their ability to generate regular income through coupon payments, which appeals to retirees and those seeking steady cash flows, unlike FDs, which usually pay interest only at maturity.

Beyond income, bonds often deliver higher returns, especially corporate bonds, which offer better yields in exchange for higher risk. Bonds also come with tax advantages that FDs lack. While FD interest is fully taxable each year, certain bonds—like municipal bonds—provide tax-free income, and long-term capital gains from bonds may benefit from indexation, reducing tax liabilities.

Liquidity is another edge for bonds. Unlike FDs, which impose penalties for premature withdrawals, many bonds trade on secondary markets, letting investors exit early and potentially secure better prices.

The bond market itself is diverse, offering choices for various risk appetites and time frames. Investors can pick from government securities, corporate bonds, or high-yield options depending on their goals and market outlook. Moreover, bonds can gain in value during periods of falling interest rates, creating opportunities for capital appreciation.

Taken together, bonds present a strong case for investors seeking a blend of steady income, growth potential, and tax efficiency beyond what traditional bank FDs can offer.