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 horizon 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 having short term and long term maturities also known as dynamic bond funds.
How does the Bond Fund Work?
- After 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 done 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 the bond fund investors. The first being capital appreciation wherein it is the rise in the Net Asset value over a period of 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.
Example
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 and 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 appreciation through such investment patterns.
Types of Bond Funds
#1 – Corporate Bonds
These types of funds invest in corporate bonds. There are many further classifications depending on the risk appetite and investment-grade classification (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. which shall result in tax exemptions.
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 interest is often difficult to determine because there is less control over the investment process. | ||
| Diversification | Hard | Invests in bonds in a diversified way. | ||
| Costs | Comparatively costlier. | Investing in such funds are far less expensive than buying individual bonds | ||
| Control Over Maturity | Bonds have a fixed maturity date. | There is no specific date as to 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. |
Advantages
- From 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 case of individual bonds.
- Because this fund is a conglomerate 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 diversified in the portfolio which is not possible in case of 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, there are professionals who handle and manage the portfolio who continually analyze the portfolio.
- Income generated from bonds is automatically reinvested and the value of the funds hence keeps appreciating.
Disadvantages
- 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.
Conclusion
- These are products offered as mutual funds 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 market 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.
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