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When you are looking to invest in bonds, you can either buy individual bonds or invest in bond funds. Both options may give you regular interest income, but differ in terms of:
- Return predictability, fixed vs. market-linked returns.
- Diversification, limited vs. wide exposure.
- Management, self-managed vs. professionally managed.
- Costs, minimal charges (low) vs. fund expenses (high).
Read this article to first understand the meaning of these options and then check out the bonds vs bond funds comparison table for more clarity.
What are Bonds?
A bond is a loan you give to an issuer (government, public sector unit, or company). The issuer pays periodic interest and returns your principal at a set maturity date. Some common bond examples are:
- Government securities (G-secs)
- State Development Loans (SDLs)
- PSU/Corporate bonds
- Tax-free bonds issued by authorities, like NHAI.
Corporate Bonds Are Usually Rated
Credit rating agencies such as CRISIL, CARE, and ICRA evaluate the financial strength of companies or institutions that issue bonds. They assign ratings to indicate how likely the issuer is to repay interest and principal on time. Let’s understand in detail:
| AAA is the Highest Rating | The Lower Ratings |
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How Do You Earn Returns from Bonds?
If you hold corporate bonds to maturity, your cash flows are the coupons + return of principal (unless the issuer defaults). In contrast, if you sell your bond before it matures, the price you get depends on the market and interest rate changes. Let’s see how:
| When Interest Rates Go Up | When Interest Rates Go Down |
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Some Major Bond Risks You Must Know
One of the biggest risks in bond investing is “credit risk”. It is the chance that the issuer may fail to pay interest or return your money when the bond matures. Usually, bonds with a higher credit risk (reflected through ratings) offer comparatively higher coupon rates to attract investors.
Additionally, some other bond risks you must know before investing are:
1. Liquidity Risk
Liquidity risk means the difficulty of selling your bond in the secondary market at a fair price. Some corporate bonds in India don’t trade frequently on exchanges. In such cases, you might need to offer a lower price to attract a buyer or wait longer to sell. Thus, low trading activity = higher liquidity risk.
2. Inflation Risk
The rising inflation usually reduces the real value of your bond returns. For example,
- Let’s say your bond pays a fixed coupon (say 7% per year).
- However, inflation rises to 8%.
- Now, your purchasing power actually declines, even though you’re still receiving 7%.
This impact is felt more when you invest in bonds with long maturity periods. It erodes the real value of both your interest income and your principal.
3. Reinvestment Risk
Reinvestment risk is the possibility that you may have to reinvest your bond’s interest or maturity proceeds at lower rates in the future. For example,
- Let’s say you buy a 5-year bond paying 7%.
- Three years later, similar bonds offer only 5%.
- When your bond matures, you can’t find another investment with the same 7% return.
- As a result, your overall income falls.
This risk is more noticeable when interest rates are on a downward trend or when you hold short-term bonds that mature soon.
What are Bond Funds?
A bond fund is a pooled debt mutual fund or ETF that invests in a basket of many bonds. As an investor, you buy “units” of a bond fund, instead of owning the debentures directly. On your behalf, a dedicated fund manager buys and sells bonds and distributes returns through the fund’s net asset value (NAV).
For more clarity, let’s see how it works:
- You buy units of a fund (open-ended or closed-ended).
- The fund pools investor money and buys a diversified portfolio of bonds.
- A fund manager actively manages holdings to meet the fund’s objective.
How Do You Earn Returns from a Debt Mutual Fund?
A bond fund’s NAV (Net Asset Value) shows the current market value of all the bonds it holds. When interest rates or market prices of bonds change, the NAV also fluctuates accordingly. Now, you can earn from a bond fund in two ways:
- Regular income, if the fund declares interest payouts (dividends).
- Capital gains, when you sell your fund units (gains happen when the current NAV is higher than the NAV at which you purchased the units).
A debt mutual fund may be preferred if you want to invest in multiple bonds through a single product, without having to study or buy each bond yourself.
Some Major Bond Fund Risks You Must Know
One of the major risks with debt mutual funds is that you are exposed to “managerial risk”.
Usually, bond funds are managed by professionals who decide which bonds to buy, sell, or hold. Thus, your returns depend partly on the skill and judgement of the fund manager.
For example, let’s say the manager makes poor decisions by selecting lower-quality issuers or investing in bonds with longer maturities when interest rates are rising. Now, the NAV may fall, and so do your returns.
Additionally, some other debt mutual fund risks you may consider are:
1. Market / Interest Rate Risk
When interest rates in the economy go up, the value of the bonds held by the fund falls.
As a result, the fund’s NAV (price per unit) also drops. In contrast, if rates decrease, the NAV usually goes up.
Thus, the NAV of a bond fund fluctuates with interest rate movements.
2. Credit Risk
Some bonds in the fund may be issued by companies with lower credit ratings. If any of these issuers delay or fail to make payments, the value of those bonds falls, and this reduces the fund’s NAV.
3. Redemption Pressure Risk
This risk arises when many investors withdraw money from the bond fund at the same time. For example, during market stress or when interest rates rise sharply.
Now, to meet these redemptions, the fund may need to immediately sell some of its bonds, even if market prices are low. This “forced selling” may push the NAV down further, which negatively impacts the investors who stay in the fund.
Bonds vs Bond Funds: How Do They Differ?
Till now, you must have understood the meaning, working, and risks of both these fixed-income products. Now, to gain more clarity, check out this side-by-side comparison table of bonds vs bond funds:
| Aspect | Bonds | Bond Funds |
|---|---|---|
| Diversification |
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| Yield (Return) |
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| Costs |
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Which Financial Product May Suit Me – Bonds vs. Bond Funds?
The selection usually depends on your risk appetite and investment objectives. Still, you may:
- Choose Individual Bonds if:
- You want steady and predictable interest income.
- You can hold the bond till maturity.
- You can assess the issuer’s financial strength.
- You prefer direct control over investments.
- Choose Bond Funds if:
- You want diversification by investing in a single product.
- You prefer high liquidity.
- You rely on professional fund management.
- You accept NAV fluctuations.
To Sum It Up, Bonds vs. Bond Funds Are Two Different Ways To Invest in the Debt Market!
So now you know that bonds and bond funds are two fixed-income products that operate differently. While you can directly invest in individual bonds, a debt mutual fund invests in many bonds based on its investment objective.
When it comes to choosing between the two, your choice depends on your risk appetite, financial knowledge, and investment goals. If you wish to buy individual bonds, you may visit the GoldenPi platform. Here, you can find a wide range of bond options with detailed information on yields, issuers, maturity dates, and credit ratings.
Bonds vs Bond Funds FAQs
Are bond funds rated by credit rating agencies?
No. Credit rating agencies rate individual bonds or issuers, not the mutual funds that hold them. However, the bonds within the fund’s portfolio may carry ratings from agencies like CRISIL, ICRA, or CARE, indicating their credit quality.
How can I buy AAA-rated bonds?
You can visit the GoldenPi platform and invest online. All you must do is complete your KYC, browse through available AAA-rated bonds, and lastly, make the payment.
Do I need to pay annual charges when buying individual bonds?
No. There are no annual or recurring charges for holding individual bonds. You may only incur one-time costs, such as brokerage or transaction charges, at the time of purchase or sale (depending on your broker or platform).
Can I get a regular income from debt mutual funds?
Yes, if you choose the dividend (income distribution) option. The fund may pay you periodic income based on its performance. However, these payouts are not fixed and can vary depending on market conditions and fund returns.
Disclaimer:
This information is for general information purposes only. GoldenPi makes no guarantee on the accuracy of the data provided here; the information displayed is subject to change and is provided on an as-is basis. Nothing contained herein is intended to or shall be deemed to be investment advice, implied or otherwise. Investments in the securities market are subject to market risks. Read all the offer-related documents carefully before investing.
Bonds or non-convertible debentures (NCDs) are regulated by the Securities and Exchange Board of India and other government authorities. GoldenPi Securities Private Limited is a registered debt broker and acts as a distributor and not as a manufacturer of the product.
