When looking to invest in debt instruments, investors generally have two main options – investing directly in bonds or opting for debt mutual funds. Both offer regular income through interest payments but there are important differences between the two that investors need to understand.
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What are bonds?
Bonds, also known as fixed income securities, are instruments issued by governments, companies or other entities where the issuer borrows money from the investor for a fixed period of time at a specified rate of interest. Some key aspects of bonds include.
- Tenure: Bonds typically have a fixed maturity period ranging from a few months to over 30 years.
- Interest rate: The issuer promises to pay a pre-determined rate of interest regularly until maturity. Interest rates are usually fixed when the bond is issued.
- Principal amount: At maturity, the issuer returns the amount borrowed, which is called the principal or face value of the bond.
- Types: Important bond types in India include government securities (G-secs), corporate bonds, municipal bonds and bonds issued by public sector companies.
- Liquidity: Bonds can be bought and sold in the secondary market but liquidity depends on factors like bond issue size, credit rating etc. Smaller issuances may have low liquidity.
Bonds directly expose investors to the credit risk of the issuer and interest rate risk over the bond’s tenure. Investors need to hold bonds till maturity for assured returns.
What is a debt fund?
A debt mutual fund is a professionally managed investment scheme that pools money from multiple investors and invests it predominantly in debt securities like bonds, commercial papers, certificates of deposit issued by corporations and the government. Some key points about debt mutual funds are below.
- Diversification: Debt funds invest in a variety of debt instruments across maturities, sectors and credit profiles offering higher diversification than direct bond investing.
- Professional Management: Full-time fund managers evaluate investments and manage portfolio risks on behalf of investors.
- Multiple Options: Numerous funds catering to different risk appetites – liquid, ultra short term, short term, medium term, long term, gilt funds etc.
- High Liquidity: Open-ended debt funds can be redeemed on any business day and switches allowed between schemes.
- Returns: Funds aim to generate regular income through interest and capital appreciation. Returns depend on portfolio performance and market conditions.
Bonds vs debt funds: Key differences
Now let’s compare some key differences between direct bond investment vs debt mutual funds.
Bonds typically have higher minimum investment amounts like Rs.10,000-25,000 whereas debt funds require as low as Rs.500-1,000 to start.
Direct bonds can only be sold in the secondary market which may have low liquidity. Debt funds offer high liquidity with daily NAV and ability to redeem partially or fully.
Bonds have a fixed tenure while debt funds are open-ended with no fixed maturity.
Bond returns depend purely on performance of that single security. Debt funds smoothen returns through a diversified portfolio.
Bonds require active monitoring of the issuer and timing the investment to maturity. Debt funds are professionally managed regardless of market conditions.
Bond portfolios can hold only a few securities based on available investment. Debt funds instantly offer diversification across many issuers, maturities and credit ratings.
Fees and minimum investment
Debt funds levy annual fees of around 1% but have very low minimum investments. Bonds have no ongoing annual fees but require larger investment minimums.
Direct bonds are best suited for larger individual investors who can dedicate resources to research and hold securities till maturity. Debt mutual funds are more appropriate for retail investors due to lower entry barriers, diversification and daily liquidity. Both instruments have their place depending on investment size and goals.
Both bonds and debt mutual funds are viable options for generating regular fixed income in Indian portfolios. However, bonds are more suitable for higher net worth individual investors willing to carry credit and interest rate risks for higher potential returns.
On the other hand, debt mutual funds provide instant diversification, professional management and high liquidity better appealing to retail investors even with modest amounts to start. Overall, a combination of both direct bonds and debt funds through a systematic investment plan works well for a balanced debt portfolio.