What is Bond Fund?
The bond fund, also known as a debt fund or an income fund, is a mutual fund that invests in bonds and other debt securities paying dividends periodically and not actually possessing any maturity date, unlike individual bonds. It basically pools the money of investors with an objective to generate them a stream of income by investing in mainly fixed income securities like government securities, bonds, debentures, debt securities, fixed deposits, etc.
These funds usually invest in the following:
- Short-term investments – 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– for those investors with an investment horizon of 3 or more years.
- Government securities – for investors with no appetite for default risk and hence considered to be the safest.
- Bonds are having short-term and long-term maturities, also known as dynamic bond funds.
How does the Bond Fund Work?
- After the pooling of funds of investors, the fund manager who is in charge invests all the funds so 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.
- The main objective of the fund is to optimize the income and earnings and to minimize the credit and default risk of principal and also interest payments.
- There are majorly two sources of income for bond fund investors. The first being capital appreciation, wherein it 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 some time.
The second source of income is dividend income. The dividend is paid out at certain intervals of time, which depends on the surplus funds available.
Let us consider the example of the HDFC Corporate bond fund with the NIFTY Corporate bond 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 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.
Types of Bond Funds
#1 – Corporate Bonds
These types of funds invest in corporate bonds. Many further classifications are depending 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..
Differences Between Bonds and Bond Funds
|Point of Difference||Bonds||Bond Funds|
|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. is often difficult to determine because there is less control over the investment process.|
|Diversification||Hard||Invests in bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. in a diversified way.|
|Costs||Comparatively costlier.||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.|
- 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 is a company or corporation made up of different businesses that operate in various industries or sectors, often unrelated. It holds a stake in multiple smaller companies that choose to manage their business separately to avoid the risk of being in a single market, thus, taking advantage of diversification. of many bonds, in case of default of payment by one kind of bond, the impact would be lesser.
- 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. in the portfolio, which is not possible in individual funds.
- Though there is no particular date of maturity, the investor can withdraw at any point in time 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 hence keeps appreciating.
- 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 would fall.
- The fee structure depends on the mutual fund company, their specialization in a particular product, and their 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 discretion of the fund manager, they may close the fund to new investors.
- These are products offered as mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. ULIPs by pooling all the funds of investors. They may be customized as per the needs of investors. They are suitable for the long-term goals of the investors. This is also suitable for investors who seek diversification.
- The returns are usually higher than the money marketMoney MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability. 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.
- So, if the specialized fee doesn’t seem to be much big of a problem, these are best suited for investors seeking income over medium and long terms and those looking for a reasonably stable rate of return with moderate risk.
In case of any doubts, investors should consult their financial advisors about the suitability of the product.
This has been a guide to What is a Bond Fund & its Definition. Here we discuss the types of bond fund and how does it work along with and examples, advantages and disadvantages. You can learn more about from the following articles –