What is a Bond Fund: Meaning, Types and Benefits of Investing in Bond Funds

Bond funds refer to an investment instrument that pools money to invest in fixed-income instruments such as government, corporate or municipal bonds. 

The main objective of these funds is to build a diversified fixed-income portfolio and provide a steady income stream for investors. Offered by mutual fund companies, ULIPs (Unit-Linked Insurance Plans), and other institutions, these funds are ideal for investors with low to no risk-taking capacity who are seeking relatively higher returns.

In this blog, we discuss everything about bond funds, from how they work, their different types, tax implications and how to choose the right one.

Quick Synopsis 

• Bond funds aim to generate returns via capital appreciation and periodic dividends.
• Key performance metrics of bond funds include NAV, yield, tax-equivalent yield, credit quality, expense ratio and total return.
• Dividends are taxed when received and capital gains from redemption are taxed at the income tax slab rate, regardless of holding period.

How Does a Bond Fund Work? 

Bond funds are professionally managed portfolios comprising multiple individual bonds. These bonds are issued by governments, corporations and other entities to raise capital. 

Each bond comes with a maturity date, on which the bond issuer repays the face value to the investor. Bonds are sold at face value and their prices often fluctuate based on interest rates, inflation or the issuing company’s performance. The issuer also pays a coupon (regular interest), which stays the same during the bond tenure.

The objective behind issuing bond funds is to increase profit margin. This can happen in two ways:

• By capital appreciation, which is when the bond fund's NAV goes up gradually.
• By paying dividends to the investors at periodic intervals.

Different Types of Bond Funds 

Understanding the various types of bond mutual funds available in India helps you make the most appropriate investment decision. Here are a few key categories to explore:

• Treasury Bonds: These are issued by the federal government, making them the safest bond option among investors due to the lack of credit risk. 
• Corporate Bond Funds: Large corporations issue such bonds to raise capital for several projects. They carry a higher risk profile than treasury bonds because of the creditworthiness of the issuer. 
• Bond Exchange-traded Funds: Through Bond ETFs, investors gain exposure to the bond market easily. These are traded on the stock exchange throughout the day and are sold over the counter by brokers. 
• State and Municipal Bonds: These bonds are issued to raise funds for projects (healthcare, education and infrastructure) developed for the sake of the public.
• Banking and PSU Funds: These funds invest at least 80% of assets in debt instruments issued by Public Sector Undertakings and banks.  
• Gilt Funds: As they are supported by the government, these funds have little to no risk of default, and invest a minimum of 80% funds in government securities. 
• Floater Funds: They invest approximately 65% of their funds in floating-rate instruments, whose interest payouts go up and down depending on the economy’s current interest rates.
• Callable Bonds: The issuer can redeem these bonds early to create a premium result for the investors.
• Mortgage-backed Securities: These financial instruments create a connection between the two worlds: real estate and investment. 
• Zero-coupon Bonds: Investors can not gain interest periodically by choosing zero-coupon bonds, issued at a discount to face value.

Key Benefits of Bond Mutual Funds 

• Professional Management: Expert fund managers with decades of experience working in the debt market actively manage bond funds. They monitor market ups and downs, make strategic decisions and search for attractive wealth-creation opportunities.
• Portfolio Diversification: As they invest in various kinds of debt securities, it ensures portfolio diversification and distributes risk among various issuers. This way, you remain protected from the negative outcomes because of adverse market swings.  
• Tax-free Income: Investing in specific bond funds can offer tax advantages, making them a better option for investors who are looking for better return (post-tax) options.

How to Choose a Bond Fund? 

Bond fund investment requires considering the following factors:

• Investment Goal: Pick a fund that aligns with your future investment goals.
• Risk-tolerance: It is highly advisable to choose a fund that covers your risk-taking capacity; otherwise, staying invested for the long run becomes difficult. 
• Review Past Performance: Assess the fund's past performance, such as 3 or 5-year annualised returns, before investing.
• Additional Fees: Consider fees such as the expense ratio to ensure higher returns from your bond investments.

Performance Metrics to Track in Bond Funds 

When reviewing a bond fund's past performance, it's essential to understand the following terms to assess whether the fund aligns with your investment goals. 

• Share Price: It is the Net Asset Value (NAV) per share, which represents the value of one share on a given day.
• Yield: It represents the percentage return on a bond fund's NAV, including interest, capital gains and dividend income. 
• Tax-equivalent Yield: The yield of a bond fund is adjusted to reflect the tax benefits offered by specific bond mutual funds, such as municipal bonds.
• Credit Quality: It measures the overall creditworthiness and risk of the bond funds it holds, based on the credit ratings assigned by rating agencies.
• Expense Ratio: It is the annual fee charged to cover operational costs, such as management and administrative fees.
• Total Return: It denotes the overall return, considering fluctuations in share price and income distributions.

Tax Implications on Bond Mutual Funds 

In bond mutual funds, any returns you receive are subject to taxation under the Income Tax Act, 1961. Dividends are taxed when they are received, while gains from selling or redeeming mutual fund units are taxed as capital gains. These capital gains are taxed at your income tax slab rate, regardless of the holding period.

What are the Risks in Bond Funds?  

• Risk of Default: High-yield bond funds, in particular, are more exposed to default risk because they invest in lower-rated bonds.
• Interest Rate Risk: As these funds primarily invest in debt instruments, they are more susceptible to interest rate risk, especially in the case of bond funds with long maturity periods. 
• Principal Risk: This refers to the risk that you could lose part or all of your original investment. This can happen if you sell your shares when the fund’s net asset value (NAV) has declined. 

What is the Difference Between Bond Funds vs. Bonds? 

The table highlights the difference between bond funds vs. bonds:

Final Word

Bond funds are suitable options for investors who want to gain access to the debt market. They are considered a more convenient choice than buying an individual bond when commissions and other costs are taken into consideration. 

However, to avail all the benefits, choose the right bond fund by evaluating factors such as the latest NAV, bond yield, total return and expense ratio.