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Bond Funds – Types, Benefits and Taxation

Many individuals find bond funds efficient to invest in rather than buying securities separately.  These funds help an investor earn monthly income. To learn more about a bond fund, its types, examples, benefits, and more scroll through this page. 

What Is a Bond Fund?

A bond fund also known as a debt fund is used to pool money from different investors to buy debt instruments or a portfolio of bonds. These funds do not have any maturity period for principal repayment. 

A bond fund provides instant diversification to investors with a low minimum investment capacity. Investors with a high-risk appetite can opt for a bond fund. 

How Does a Bond Fund Work?

If you want to invest in a bond fund you have to put your money into a pool which a portfolio manager maintains. Usually, the portfolio manager buys and sells securities depending on the market conditions. They rarely hold the bonds until their maturity. 

The following step highlights how bond funds work:

  1. Investor Contributions: Investors purchase units or shares, collectively to form the fund’s total assets.
  2. Portfolio Formation: The portfolio manager selects bonds from different issuers, considering maturity, credit quality, and yields to create the fund’s portfolio.
  3. Coupon Payments: As you receive interest from these bond funds, the income from this fund is distributed to investors as regular dividends.
  4. Net Asset Value (NAV): NAV per share is calculated by subtracting expenses from the fund’s assets and dividing by the total number of shares outstanding. It represents the buying or selling price of shares in the fund.

Types of Bond Funds

There are different types of bond funds available in India. These are: 

1. Government Securities Fund

This bond fund invests in government bonds issued by the Reserve Bank of India with maturities ranging from 15 to 30 years. Though government bond funds will not provide high yields however they will offset the credit risk of the bond.

2. Municipal Bond Fund

These funds invests in bonds issued by local and state governments to support capital projects. These bonds are exempted from central and state taxes. It provides a slow and steady income and therefore is perfect for risk-averse investors.

3. Corporate Bond Fund

The corporate bond funds invest in securities (Non-Convertible Debentures) issued by institutions or companies for capital raising. The yields and risks involved in these bonds are comparatively higher than the government and some municipal bond funds.

4. Inflation Indexed Bond Fund

Invests in bonds linked to prevailing inflation rates in India, aiming for capital appreciation and income during inflation. These funds usually invest in Treasury Inflation Protected Securities (TIPS) whose face value changes to maintain a balance with the Consumer Price Index (CPI).

5. Income Bond Funds

An income bond fund invests in a variety of bonds to generate regular income. These funds’ portfolio includes corporate bonds, government bonds, and other debt securities.

6. Dynamic Bond Fund

These funds adapt their portfolio duration dynamically based on market conditions for returns in both falling and rising interest rate scenarios.

Example of Bond Funds

ICICI Prudential Corporate Bond Fund, HDFC Corporate Bond Fund, Sundaram Corporate Bond Fund, UTI Bond Fund, and Kotak Corporate Bond Fund are examples of bond funds in India.

Benefits of Bond Funds

Here are the benefits you can get by opting for bond funds:

1. Diversification

Bond funds own various bonds with different maturity dates, reducing the impact of a single bond’s performance. The minimum investments for most bond funds are low in order to make individual bonds more affordable.

2. Professional Management

Skilled portfolio managers analyse bond issuers and market data for informed investment decisions. The managers choose securities based on individual analysis, sector allocation, and yield curve evaluation.

3. Liquidity and Convenience

Bond funds allow daily buying or selling. Investors can reinvest income dividends automatically and make additional investments anytime.

4. Income Stream

Most bond funds offer monthly income, suitable for those seeking stable, regular earnings. Dividends can be reinvested automatically for compounding growth.

5. Potential for Tax-Free Income

A municipal bond fund helps in reducing taxes for some investors. Higher tax brackets may yield better after-tax returns by investing in tax-free municipal bond funds.

Risk Involved in Bond Fund

The following points highlights the risks involved in a bond fund:

1. Interest Rate Risk

Rising interest rates can lead to declining bond prices, and vice versa. Bond funds with longer maturity periods are more sensitive to interest rate changes.

2. Credit Risk

The bond funds are categorised by credit quality, with potential default risk if issuers cannot make payments. High-yield bond funds pose higher credit risk.

3. Principal Risk

Selling fund shares at a lower Net Asset Value (NAV) than the purchase date may result in a loss.

Bond funds try to mitigate default and call risks by spreading investments across many bonds. However due to diversification, the impact of single bond defaulting reduces.

Taxation on Bond Funds

A bond fund is taxed as per the following basis:

1. Tax on Income

The income from bond funds are generally taxed on a federal and state-level basis at the yearly income tax rates.

2. Tax on Capital Gains

An investor can earn capital gain from bond funds in two ways. The profit earned from selling the bond fund is taxed at a normal interest rate. On the other hand, if you incur losses it will also generate a tax benefit.

Conclusion

Thus, if you are an investor who is planning to diversify your investment portfolio then you can opt for bond funds. Furthermore, buying a bond fund is not only easier but also less expensive compared to buying individual bonds. 

FAQs

Is a bond fund a good investment?

Bond funds are a good investment for those looking for regular income and capital preservation. However, remember the returns from these bonds are lower in comparison to other investment instruments. 

How often does a bond fund pay dividends to you?

Bond funds usually pay dividends to you on a monthly, quarterly and annual basis. This dividend amount depends on the interest rate of the bonds. 

Which are the best bond funds to invest in India?

HDFC Corporate Bond Fund, SBI Corporate Bond Fund, ICICI Prudential Corporate Bond Fund, L&T Triple Ace Bond Fund, and Aditya Birla Sun Life Corporate Bond Fund are the best bond funds to invest in India.

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