Banks offer very low interest rates on fixed deposits (FD) due to the low policy rates set by the Reserve Bank of India (RBI). As DF rates are lower than the rate of inflation, investors face a devaluation of the money invested in DF at maturity.
Banks, on the other hand, lend money collected from DFs and other investors to borrowers at a higher rate. The difference between the FD rate and the lending rate allows banks to meet their current expenses as well as to make profits.
Along with equity, companies take out loans to meet recurring spending needs and to improve return on equity.
In addition to soliciting financial institutions for loans, companies may decide to directly solicit the general public to raise funds by issuing a financial instrument called a bond. So buying or investing in bonds means lending money directly to the issuer.
The issuing company in return issues a bond promising to repay the principal at maturity and also to make a regular payment until maturity – that is, throughout the term – at an interest rate specified called coupon.
Loss of purchasing power of invested capital: immediate relief not in sight for FD investors
The spread between deposit rates (FD) and lending rates allows companies to offer bonds at a coupon rate higher than the FD rate but lower than the lending rate at which they borrow money from banks and financial institutions.
As a result, investors earn a higher return than FD rates, while companies can borrow at a rate slightly lower than bank lending rates. It is therefore a win-win situation for both investors and companies.
Bonds also offer investors the opportunity to sell instruments in the secondary market at a price above face value to obtain a higher return.
Investors may face credit and default risks if investments are made in bonds with a low rating, when the issuer does not pay the interest and even the principal amount due to a financial crisis.
The market value of a bond may increase due to a drop in interest rates afterwards. However, a subsequent rise in interest rates would cause the bond’s market value to decrease. Thus, bonds face interest rate risk, which increases with duration.
Besides FDs, bond investors may also face devaluation of invested capital – especially after paying tax – due to the inflation rate higher than the coupon rate. Even with a lower interest rate than taxable bonds, non-taxable bonds can offer better returns to investors in higher tax brackets.