Navigating Investment Avenues: Bonds Versus Debt Mutual Funds

Investing is a critical tool for building wealth and achieving financial goals. When it comes to fixed-income investments, two popular options that often arise are investing directly in bonds or opting for debt mutual funds. In this special report, Vardan Pandhare delves into both the options to explore the investment opportunities, growth and prospected returns.

India’s post-pandemic investing culture has ushered in a new generation that values financial management and takes investments seriously. However, navigating the vast capital market brimming with opportunities can be daunting and confusing, especially for beginners seeking to achieve their financial goals. So, how should one approach investing in such a complex landscape? Experts often advise starting with modest capital and opting for less risky investment choices such as mutual funds and bonds. 

These options offer risk management while providing potential returns to grow your capital. In this article, we explore the fundamentals of both mutual funds and bonds, comparing their features to help you make an informed decision about where to invest your hard-earned money. Let’s explore these investment avenues in-depth to find the most viable option that aligns with your financial objectives.

Understanding Bonds

Bonds serve as investment instruments designed to support governments or companies in raising funds for their projects and initiatives. They can be likened to loans provided by investors to these entities. Unlike owning shares or direct investments in a company, bondholders receive interest payments as a return on their investment. Bonds are considered fixed-income investments, offering consistent returns to investors. When a bond is purchased, the investor essentially lends money to the issuing entity, and in return, the issuer commits to paying regular interest on the borrowed funds.

Investment Horizon

Bond markets are categorised based on the type of bond and the type of buyer involved. These markets can broadly be classified into two groups: primary markets and secondary markets. In the primary market, original issuers directly offer new debt instruments to investors. Bonds purchased in the primary market can later be traded in the secondary market. Different types of bonds are available for investment, including government bonds, convertible and non-convertible bonds, zero-coupon bonds and municipal bonds.

Benefits of Bond Investments

1. Predictable and Stable Returns: Bonds provide a steady stream of income as they typically pay interest twice a year.
2. Safety of Capital: Holding bonds until maturity ensures that bondholders receive the full principal amount back, making bonds a reliable way to preserve capital while investing.
3. Diversification of Risk: Investing in bonds can help reduce exposure to the volatility often associated with equity ownership.
4. Lucrative Interest Rates: Bonds often offer higher interest rates or payments compared to traditional bank deposits. The interest, known as the coupon, is paid regularly during the bond’s term.
5. Capital Gain: Bondholders have the option to sell their bonds to third parties. If sold at a higher price than the original cost, the investor realises a capital gain.
6. Collateral Usage: Government bonds, in particular, can serve as collateral when seeking a bank loan, providing additional financial flexibility

Considerations before Investing in Bonds

Interest Rate Risk: Bonds are sensitive to changes in interest rates. When rates rise, the value of existing bonds may decrease. Conversely, falling rates can increase bond prices.
Credit Risk: Corporate and municipal bonds carry the risk of default, which means the issuer may fail to meet its interest or principal payment obligations. Assessing the creditworthiness of the issuer is crucial.
Liquidity: Some bonds may lack liquidity, making it difficult to sell them quickly in the secondary market. Investors should consider the liquidity aspect before investing in certain bonds.

Bonds play a crucial role in the stock market, providing a stable and predictable investment option for investors. As fixed-income securities, they offer consistent returns and a degree of safety for the invested capital. Understanding the various types of bonds and their benefits can help investors make informed decisions to suit their financial goals and risk tolerance. Whether seeking steady income, capital preservation or diversification, bonds can be a valuable addition to an investor’s portfolio.

Types of Bonds

A diverse range of bonds exists, each catering to specific investor preferences and market conditions. Here are some of the most common types:
1. Fixed Rate Bonds — Fixed rate bonds provide predictable interest payments until maturity, regardless of market fluctuations. Investors enjoy guaranteed returns throughout the bond’s tenure. For example, an investor buys a 10-year fixed rate government bond of Rs 1,000 with a coupon rate of 7.5 per cent. He will receive a fixed interest of Rs 75 annually every April until April 20, 2023.
2. Floating Rate Bonds — Floating rate bonds offer variable interest rates, linked to a benchmark, during the bond’s term. The coupon payments fluctuate based on the benchmark’s performance. For example, an investor purchases an eight-year floating rate bond issued in 2015 with interest set 40 points higher than the prevailing National Savings Certificate interest rate. The bond’s coupon payment varies with changes in the NSC rate.
3. Zero Coupon Bonds — Zero coupon bonds do not pay regular interest during their tenure. Instead, they are issued at a discount and redeemed at face value, allowing investors to realise the difference as yield. For example, an investor buys a 20-year zero coupon bond with a face value of Rs 1,000 at Rs 700. After 20 years, the issuer pays Rs 1,000 to the bondholder.
4. Perpetual Bonds — Perpetual bonds have no maturity date with the issuer paying coupon payments to bondholders indefinitely without repaying the principal.
5. Inflation-Linked Bonds — These bonds aim to protect against inflation’s impact on the face value and coupon payments. The principal is adjusted based on inflation and coupon payments are made accordingly. For example, an investor purchases an inflation-linked bond with a face value of Rs 100. After a year, the inflationadjusted principal becomes Rs 107, and the coupon is paid based on Rs 107.
6. Convertible Bonds — Holders of convertible bonds have the option to exchange the bond for a predefined number of equity shares in the issuing company within a specified timeframe. Alternatively, they can choose to receive the principal repayment at maturity.
7. Callable Bonds — Callable bonds offer high coupon payments and grant the issuer the right to recall the bonds at a predetermined price and date.
8. Puttable Bonds — Puttable bonds grant the bondholder the right to return the bond and receive the principal repayment on a pre-agreed date before maturity. These bonds typically offer lower returns as a benefit to investors.

Understanding Debt Mutual Funds

Debt mutual funds pool money from investors and invest in a diversified portfolio of fixed-income securities such as bonds, debentures, government securities and money market instruments. These funds are managed by professional fund managers who aim to generate income and capital appreciation.

Benefits of Investing in Debt Mutual Funds

∎  Professional Management — Debt mutual funds are managed by experienced professionals who have expertise in analysing and selecting the right mix of fixedincome securities.
∎  Diversification — By investing in debt mutual funds, investors gain access to a diversified portfolio of bonds and other debt instruments, even with a relatively small investment.
∎  Liquidity — Debt mutual funds can easily be bought or sold, offering investors the flexibility to exit their investment whenever required.
∎  Tax Efficiency — Debt mutual funds provide tax advantages such as indexation benefits, which can help reduce tax liabilities on long-term capital gains.

Considerations for Investing in Debt Mutual Funds

∎  Expense Ratio — Investors should consider the expense ratio of the mutual fund, which represents the cost of managing the fund. Lower expense ratios can enhance overall returns.
∎  Credit Risk — Debt mutual funds are subject to credit risk associated with the underlying bonds. Evaluating the credit quality of the fund’s portfolio is essential.
∎  Interest Rate Risk — Debt mutual funds also face interest rate risk. A change in interest rates can impact the fund’s net asset value (NAV) and returns.
∎  Past Performance — Analysing the historical performance of the debt mutual fund and its consistency over different market cycles can provide insi ghts into its reliability.

Types of Debt Funds

Having understood the benefits of debt funds, let us explore the various types available:
1. Short-Term Funds — Short-term debt funds have a maturity period of 1-3 years and invest in government securities, debt and money market instruments. They suit investors with low to moderate risk appetites, performing well when the interest rates are high. These are ideal for those looking to invest for 9-12 months with a low-tomoderate risk appetite.
2. Ultra Short-Term Funds — These funds have maturities of less than a year, investing mainly in ultra-short-term debt securities and a small portion in long-term securities. Ultra short-term funds offer low-risk options for investors with a 1-12 month investment horizon.
3. Income Funds — Income debt funds invest in debt securities with varying maturities, predominantly for the long term, around 5-6 years. They invest in government securities and corporate bonds, considering changing interest rates. These are suited for those with a slightly higher risk appetite and longer investment horizons.
4. Liquid Funds — Liquid debt funds have a very short maturity period of 91 days, making them easily convertible to cash and low-risk. They invest in Treasury Bills, CDs or Certificate of Deposit, offering stable returns.
5. Dynamic Bond Funds — Dynamic bond funds dynamically adjust across long-term and short-term funds with different maturity profiles. They invest across all classes of debt and money market instruments, considering fluctuating interest regimes. They are ideal for medium to high-risk appetite investors.
6. Gilt Funds — Gilt debt funds solely invest in securities issued by central and state governments with a medium to long-term maturity. Since they are government-issued debt funds, there is no credit risk, making them a safe investment option. They are suited for those seeking long-term, government-backed investment options.
7. Fixed Maturity Plans (FMPs) — Fixed maturity plans have fixed locked-in periods, ranging from months to years. They are not affected by changing interest rates during the lock-in period, resulting in a stable net asset value (NAV). FMPs are close-ended and tax-efficient, making them an attractive alternative to fixed deposits.
8. Credit Opportunities Funds — Credit opportunities funds invest in a diverse range of instruments with varying maturities, aiming to maximise profits. These debt funds are suitable for investors seeking higher returns while being willing to take on some risk.

Features of Bonds

Bonds possess distinct features that define their nature and appeal to investors. Here are the key characteristics:
∎  Issuer: Bond issuers are entities that borrow money from investors through bonds. Common issuers include government bodies, government institutions, municipalities and corporations.
∎  Face Value: The face or par value of a bond represents the amount repayable to the bondholder at maturity. This value may differ from the prevailing bond price in the secondary market.
∎  Coupon Rate: Bond issuers compensate bondholders by paying them interest, known as the coupon payment. The coupon rate varies based on economic conditions, issuer creditworthiness, bond type and maturity.
∎  Maturity: All bonds, except perpetuity bonds, have a specific maturity date when the bondholders receive repayment. Bonds are categorised as short-term or long-term based on their maturity periods.
∎  Credit Rating: Each bond is assigned a rating by credit rating agencies, indicating its level of risk. A higher rating signifies lower risk and lower yields, while lower ratings indicate higher risk and potential for higher returns.
∎  Yield: Yield denotes the return an investor receives from a bond over a specific period. If the bond is held until maturity, the return is termed as yield to maturity (YTM). Yield can be calculated using the bond’s face value, annual interest, maturity and market price.

Conclusion
Investing directly in bonds or through debt mutual funds offers investors the potential for stable income, capital preservation and diversification. Bonds provide direct ownership and control over individual securities, while debt mutual funds offer professional management and the benefits of diversification. Both avenues have their considerations, such as interest rate risk and credit risk, which one needs to evaluate. By understanding these investment options and conducting thorough research, you can make informed decisions that align with their financial goals and risk tolerance.