What Is A Bond Fund?
The bond fund, also known as a debt or an income fund, is a mutual fund that invests in bonds and other debt securities, paying dividends periodically and not possessing any maturity date, unlike individual bonds. It pools investors’ money intending to generate an income stream by investing in mainly fixed-income securities like government securities, bonds, debentures, debt securities, fixed deposits, etc.
They may be customized as per the needs of investors. They are suitable for the long-term goals of investors as well as for those who seek diversification. The returns are usually higher than the money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders. instruments and deposit rates. They are highly liquid and can be sold at any point in time by an investor, although the fluctuating NAV might seem like a setback.
Table of contents
- A bond fund, commonly referred to as an income or debt fund, operates as a specialized form of mutual fund specifically tailored to invest in bonds and debt securities.
- By pooling the resources of numerous investors, it aims to generate income through regular dividends and fixed-income instruments, encompassing government securities, bonds, and fixed deposits.
- Bond funds span a spectrum of types, including corporate, government, and municipal/authority bonds, each representing a distinct facet of the broader bond market.
- Investing in these instruments presents the potential for superior returns compared to money market instruments and deposit rates.
Bond Fund Explained
A bond fund is offered as mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc by pooling all investors’ funds. After the pooling of investors’ funds, the fund manager in charge invests all the funds obtained in fixed income securities, bonds, etc., as mentioned above, depending on the type of investors forming the pool. Usually, investment is made in established institutions with high credit ratings.
These funds usually invest in the following:
- Short-term investments are for those investors with an investment horizonAn Investment HorizonThe term "investment horizon" refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades. of a year or less.
- Medium to Long-term investments are options for those investors with an investment horizon of 3 or more years.
- Government securities become the best investment option for investors with no appetite for default risk and hence are considered to be the safest.
Bonds are having short-term and long-term maturities, also known as dynamic bond funds. The fund’s main objective is to optimize income and earnings and minimize the credit and default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors. of principal and interest payments.
There are majorly two sources of income for bond fund investors.
- The first is capital appreciation, which is the rise in the Net Asset valueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity's liabilities from the total value of its assets and dividing the result by the total number of outstanding shares. over time.
- The second source of income is dividend income. The dividend is paid out at certain intervals, depending on the surplus funds available.
A bond fund is available in different forms, which include:
#1 – Corporate Bond Funds
These types of funds invest in corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.. Many further classifications depend on the risk appetiteThe Risk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. and investment-grade variety (based on credit rating).
#2 – Government Bonds
They are the safest type of funds because there is a government guarantee.
#3 – Municipal/Local Authority Bonds
Investment in bonds issued by state governments, local authorities, municipal agencies, etc., shall result in tax exemptionsTax ExemptionsTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only..
Let us consider the example of the HDFC Corporate bond fund with the NIFTY Corporate bond fund index as the benchmark for the fund. The suggested investment period of the bond says 6-12 months. It would be an open-ended scheme investing in moderately risky bonds. The investment pattern would be well-diversified, say investing 80% of the amount of the fund, at the very least, in bonds with a credit rating of AAA and above.
The objective of such funds would be to generate income and expect capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets. through such investment patterns.
These funds offer a lot of benefits to investors who want to make easy investments for lenient returns. Let us have a look at the pros of this type of investment:
- From the investor’s viewpoint, these are lucrative compared to bonds because it is easier to partake in bond funds than in individual bonds solely.
- The transaction costs need not be paid as high as those in the case of individual bonds.
- Because this fund is a conglomerateConglomerateA conglomerate in business terminology is a company that owns a group of subsidiaries conducting business separately, often in distinct industries. It reflects diversification of operations, product line and market to allow business expansion. of many bonds, the impact would be lesser in case of default of payment by one kind of bond.
- There is an added advantage of diversification wherein even a lower investment would be diversifiedInvestment Would Be DiversifiedA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income., which is impossible in individual funds.
- Though there is no particular maturity date, the investor can withdraw at any point by receiving the Net Asset Value (NAV).
- For these, some professionals handle and manage the portfolio that continually analyzes the portfolio.
- Income generated from bonds is automatically reinvested, and the value of the funds keeps appreciating.
Besides the advantages, bond funds also have some limitations, which are a must for investors to know about. Here is a list of disadvantages of these funds:
- The bond funds, like bonds, react to interest rates prevailing in the market. The lower rate in the market increases the bond demand, and hence the bond price rises. On the contrary, if the interest rate rises, the demand will fall.
- The fee structure depends on the mutual fund company, its specialization in a particular product, and its regulations.
- The dividend payments are variable, unlike individual bond interest payments.
- It may not always be open to all investors. After reaching a threshold or at the fund manager’s discretion, they may close the fund to new investors.
Bond Funds Vs Bonds
Though bonds and bond funds sound like similar financial instruments, investors must be aware that these two are different forms of financial vehicles. Listed below are some of the differences between them in a tabular format:
|Point of Difference
|Rate of Interest
Fixed-rate of Interest provided the bonds are held to maturity and the issuer does not default.
|The exact effective rate of interestEffective Rate Of InterestEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period. rate is often difficult to determine because there is less control over the investment process.
|Invests in bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. in a diversified way.
|Investing in such funds is far less expensive than buying individual bonds.
|Control Over Maturity
|Bonds have a fixed maturity date.
|There is no specific date when the funds mature, and the investors would receive what they have invested. It has a price and can be sold at any point in time.
Frequently Asked Questions (FAQs)
Bond funds can be a good investment for those seeking income and capital preservation. They offer diversification, professional management, and access to a range of bonds. However, their returns might be lower compared to equities, and interest rate changes can affect bond prices.
Bonds and mutual funds are different types of investments. Bonds are debt securities issued by governments or corporations, while mutual funds pool money from multiple investors to invest in various assets. Bond funds invest in bonds and provide diversification but involve management fees and market risks.
Bond funds come with risks, including interest rate risk (fluctuations in bond prices due to changing interest rates), credit risk (potential default by bond issuers), and liquidity risk (difficulty selling bonds in certain market conditions). Economic factors can impact bond prices and affect fund returns.
This has been a guide to What is a Bond Fund. Here, we explain the concept along with vs bond, examples, types, advantages, and disadvantages. You can learn more about it from the following articles –