Debt Funds Vs Term Deposits: Benefits and Drawbacks

Debt Funds and Term Deposits should occupy significant share in any investor’s fixed income portfolio.

Term Deposits are issued by banks and in the US, they are called ‘Certificate of Deposits’ (CDs). Debt funds are issued by Mutual Funds and in the US, they are called ‘Bond Funds’.

CERTIFICATE OF DEPOSIT (CDs)

Benefits of Certificate of Deposit:

A certificate of deposit is similar to savings account, involving limited or no risk. However unlike savings account, CD has a fixed term and normally earns interest at a fixed rate of interest.

CDs earn higher rate of interest compared to savings account. Unlike many other instruments, CDs are insured up to $250,000 by Federal Deposit Insurance Corporation (FDIC).

Apart from obtaining CDs from banks, an investor can also obtain “brokered CDs” from deposit brokers such as brokerage firms and independent sales people. An individual can negotiate a higher interest rate with deposit brokers for larger deposit amount.

Drawbacks of Certificate of Deposit:

Callable CDs provide right to the issuing bank to terminate the CD after a set time period. In case interest rate falls, the issuing bank might exercise their call right thereby forcing the investor to look for other fixed income instruments, possibly carrying lower interest rate.

Deposit brokers issuing ‘brokered CDs’ are affiliated with investment professionals. The investor should check the credentials of such investment professionals by verifying SEC and FINRA’s online databases.

Investor should also read the fine print to understand the features of brokered CDs, since in the event of premature closure of the deposit, the investor may lose some principal amount.

DEBT or BOND FUNDS

Benefits of Bond Funds:

Bond mutual funds invest in bond and other debt securities. Bond funds aim to shield the investor’s principal amount while paying a regular income.

An investor investing in a bond fund would receive monthly dividend from the fund. Normally bond funds pay higher dividends than savings and money market accounts.

A bond fund carries lower risk and can offer stability to an investor’s portfolio skewed towards stocks. The tax on bond funds can be deferred by holding them in tax advantaged retirement accounts such as 401(k) or IRA.

Drawbacks of Bond Funds:

Like any other investment product, bond funds can also be subjected to several investment risks such as interest rate risk, credit risk and prepayment risk.

When interest rates fluctuate, the market value of bonds owned by a mutual fund too would fluctuate. As a rule of thumb, when interest rates go up, the market value of bonds owned by the fund would generally go down.

This would be reflected through lower Net Asset Value of the bond fund.

Credit risk would arise when the issuer of the bond owned by the mutual fund defaults. When interest rate falls, the issuer of the bond owned by a mutual fund may prepay exposing the mutual fund to prepayment risk. This would force the mutual fund to look for suitable alternative investment instruments that might fetch lower interest rate.

The interest from bond fund might be subjected to federal, state or local taxes. Hence an investor should go through these tax aspects before making an investment in bond funds.

Certificate of Deposits and Bond Funds are an important component of an investor’s diversified portfolio. By carefully evaluating the pros and cons of these instruments, an investor can gradually construct a robust fixed income portfolio.

Allan enjoys blogging about low risk investment including term deposit accounts and bonds. Over the last 3 years, Allan has contributed several articles to prominent personal finance blogs and publications.

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