Fixed-income investments appeal to conservative investors seeking steady returns and capital protection due to their stable nature and lower risk. Under this category in India, two of the most commonly debated options are bank fixed deposits (FD) and government-issued inflation-indexed bonds. Since both are designed to offer steady returns, they differ widely in the wiring of interest calculation, risk profile, tax treatment, and protection against inflation.
What Are Inflation-Linked Bonds?
An inflation-linked bond is a government bond issued by the government whereby the principal amount and interest payments are adjusted on the basis of the rate of inflation prevailing at the time. They are linked to the Consumer Price Index (CPI) in India. With inflation, the principal amount of the bond will be increased, and interest will be calculated on the inflated principal amount, thereby preserving the real value of returns.
These bonds fall under the classification of bonds in India issued with a sovereign guarantee by the central government, thus ensuring a low risk of default. They are available through primary auctions and are tradable on the secondary market.
What Are Fixed Deposits?
FDs are term deposits that the banks and financial institutions accept, i.e., the investor deposits a fixed sum for a certain tenure at an interest rate determined beforehand. Interest may be paid periodically during the life of an FD or, depending on the type of FD, is either compounded and paid at maturity or paid together with the principal upon maturity.
Almost all of India has fixed deposits, from banks to post offices and even NBFCs. The FDs protect capital and provide fixed returns, but these returns, to some extent, are afflicted by changes in inflation during the period of deposit.
Key Differences Between Inflation-Linked Bonds and Fixed Deposits
Core features of each must be compared to determine which option fits under the various Conditions:
1. Inflation Protection
Inflation-linked bonds adjust to inflation both in their principal value and interest payout, thus ensuring that returns maintain purchasing power. On the contrary, FDs have a fixed nominal interest rate, unaffected by inflation, and may thus dilute actual earnings should inflation arise during the tenure.
2.Issuer and Credit Risk
In India, save for a few exceptions, bonds carry a sovereign guarantee, more so if they are government-issued. Inflation-linked bonds are fairly secure from default risk since they carry a government of India backing. On the other hand, Fixed Deposits, being offered by banks or NBFCs, do hold some risk, even though they are insured for ₹5 lakh per depositor under the Deposit Insurance and Credit Guarantee Corporation (DICGC) scheme.
3.Liquidity and Exit Options
FDs typically are bound by the lock-in period, yet the facility of pre-closure with a penalty is allowed. Hence, the liquidity of FDs usually depends on the particulars of the deposits and on the particular policies set by the bank. Once issued, inflation-linked bonds may be traded in the secondary market on the basis of demand and trading volumes. Therefore, flexibility is afforded to investors who want to exit before maturity, a privilege not granted under traditional fixed deposits.
4.Tax Treatment
Interest from both inflation-linked bonds and FDs is taxed at the prevailing income tax slab of the investor. However, capital gains from the sale of bonds in the secondary market after a stipulated holding period may be indexed or charged at lower rates, depending on the prevailing tax laws at the time.
5.Return Predictability
Fixed deposits fixed the returns that are predetermined at the initiation of the deposit, thus never contingent on either market performance or inflation levels. The returns on inflation-linked bonds are therefore variable, whereby inflation determines the interest received and maturity value on future cash inflows, and thus are dependent on inflation trends throughout the bond’s term.
Conclusion
Inflation-linked bonds and fixed deposits both occupy distinct positions within India’s bond market and fixed-income investment sectors. While fixed deposits provide easy and steady earnings, inflation-indexed bonds provide a safeguard against inflation-associated volatility by sustaining inflation-linked earnings. Depending on their financial objectives, outlooks on inflation, risk appetites, and liquidity needs, an investor can select either of the two instruments.
