Important difference between Bonds and Bond Mutual Funds for Retail Investors

Before an investor can choose from Bond Mutual Funds vs Bonds, it is essential to first understand how these two financial instruments work. Both the instruments have their own unique benefits and limitations. So, the suitability of these investment instruments will largely depend on the requirements and preferences of the individual.

On a high level, direct investment in Bonds is more appropriate for the active and more informed investors, who can spend considerable time in the analysis of different Bonds. Whereas the Bond Mutual Funds might be a better option for the passive investors, and for those who would like to diversify the risk through investment in multiple Bonds.

Bonds

In order to decide that which investment is better in Mutual Funds vs Bonds, the first step is to learn about these products, and to understand how the investment would work.

The Bonds are issued by the Borrower, in order to raise capital from the lenders (Bond Subscribers). In return, the issuer agrees to make frequent interest payments on the borrowed amount, and this is known as the Coupon payment. The total Coupon/interest amount will depend on the number of Bonds that are owned by the investor.

On the maturity date of the Bond, the principal amount (Face Value) will be repaid to the lenders, along with the last Coupon payment. The investment returns are primarily generated through the Coupon payments.

Mutual Funds

A Mutual Fund scheme refers to an investment product that pools the money of multiple investors into a fund, and then uses the money to invest in financial securities. The scheme usually has a dedicated Fund Management team, that is responsible for making the investment decisions, and for maximizing the returns for the investors.

An Asset Management Company (also called Mutual Fund House) could run multiple schemes at the same time. Each scheme could invest in different combinations of financial instruments, and each could have a separate investment objective/strategy. For example, a Large Cap Equity Mutual Fund will invest the majority of pooled money into the Large Cap companies that are listed on the Stock Exchange.

Bond Mutual Funds

The Debt Mutual Fund is one of the most popular category for the investors. The Debt Funds primarily invest in the different Debt Securities and Fixed Income securities. These funds can be further sub-categorized into specific schemes.

Example: A short-term Corporate Bond Mutual Fund would primarily invest in the short-duration Bonds that have been issued by companies. Similarly, a different scheme might be investing most of the money in the Bonds issued by the Government.

So, the money invested in a Bond Mutual Fund will be used to purchase Bonds of multiple entities. As the Coupon payments are received from these Bonds, the amount could be passed on to the investors through Dividends, or it could be re-invested to purchase more Bonds in the Mutual Fund.

Bond Mutual Funds vs Bonds

All investors have their own goals and limitations when taking investment decisions. Although the main purpose of an investment is to maximize the returns for the investor, but there are other elements as well which can influence the investment decision.

Some of the most important factors have been mentioned below, which should be considered when comparing Mutual Funds versus Bonds.

Safety of investment

For Fixed Income securities, the safety of the invested amount should be a major concern for the investors. When an investment is made in the Bonds of 1 particular issuer, then the investor will be directly exposed to a Default Risk. This risk refers to the possibility that the Bond Issuer will fail to make the repayment to the investors in a timely manner.

There is a chance that the investor might not even recover the principal amount that was invested. That is why, the investor should carefully assess the financial stability of the Borrower, and then make the Bond investment. In addition, the investors could further reduce the risk by purchasing Bonds of different issuers.

In case of Mutual Funds, the investment is usually safer than a direct Bond investment. This is primarily because of 2 reasons:

As per regulatory guidelines, most of the Mutual Funds can only purchase Investment Grade Bonds. This means that the Fund will only invest in the Bonds which have a high Credit Rating.
The Mutual Fund scheme will typically purchase multiple Bonds, that have been issued by different entities. This diversification automatically reduces the exposure to a single borrower, and also decreases the overall risk of total loss of Principal amount.

Investor knowledge and time

When making a direct Bond investment, there is a need for the investor to have a good understanding of the financial situation of the Bond Issuer. So, there is a requirement for the investor to spend time in investigating all the information. This due diligence will become even more important if a big investment is being made in a single Bond issue.

The unique feature about Mutual Funds is that a dedicated Fund Manager and his/her team will be responsible for managing the funds that are being deposited/withdrawn from the Mutual Fund scheme. In addition, the team is also responsible for investing the funds in different Bonds that are available in the market.

So, in case of Mutual Funds, the investment decision is delegated to the fund management team, and the investor does not have to worry much about the allocation of money in the financial securities. However, the investor should still keep track of the fund performance, and the major exposure of the fund towards different instruments.

Maturity and investment duration

Most Bonds come with a fixed maturity date, on which the principal amount is returned to the investor. So, the investment horizon of the investor will play an important role in deciding which Bonds to purchase.

When an investor has acquired a Bond, there are two main exit options: 1. Waiting for the Maturity date to redeem the Bond, or 2. Selling the Bonds in Open market. But for some low liquidity Bonds, selling in the market might become difficult.

The Mutual Fund scheme invests in multiple Debt securities with different maturities, and this is notified in the objective/goal of the scheme. For example, a Short-Term Debt Fund will primarily invest in Debt instruments which are expiring within 1 year. But the investor could stay invested in the scheme for longer than 1 year.

The Fund will usually adjust the portfolio, where new investments will be purchased when the old securities have matured, or been sold. So, the investor could continue to hold the Mutual Fund, while the composition of the fund might change on a regular basis. In open-ended Mutual Funds, the investor can easily enter and exit the position when required.

Investment returns

One of the main reasons that an investor will have to choose between Bonds vs Mutual Funds, is the availability of the investment options at any given time. The Mutual Funds invest in multiple Bonds at the same time. So, the investment return generated by the Fund will be a weighted average of the returns generated by the Debt instruments held in the Fund Portfolio.

Also, most Mutual Funds charge different fees from the investors, in order to meet the expenses of running and managing the scheme. Perhaps the most popular fees is the Expense Ratio, which is directly deducted from the Net Asset Value (NAV) of the Fund.

In some situations, Direct investment in Bonds can generate a higher return for the investor. One reason is that the Bonds do not have a fees/Expense Ratio like Mutual Funds. Also, the investors can directly purchase some Bonds, which the Mutual Fund might not be allowed to purchase because of regulatory reasons.

In general, the yield of the Bond will be directly linked to the Credit Rating of the Bond. So, if the yield of a Bond is very high compared to a Mutual Fund, then one reason could be that the Bond is riskier, and that the Credit Rating could be low.

Taxation

The direct Bonds and Bond Mutual Funds are two separate financial instruments, and they are subject to different tax rates. In addition, there are some Bonds that have a preferential tax treatment. (Refer: How to compare yield of tax-free bonds and Taxable bonds?)

So, the investors should consider the tax implications of the investment, at both the investment time, and at the withdrawal time. Due to the concept of Time Value of Money, the timing of the tax deduction and the Cash Flow will be important as well.

For example, the annual Coupon payment by a Bond will be taxable as interest payments in that Financial Year. While in a ‘Growth’ type Mutual Fund, the Coupons might be reinvested within the scheme, and the investor will not receive any amount in the Bank account. So, the investor might only be subject to Capital Gains tax in the year when he/she decides to exit from the scheme.

Accounts

Another minor point to be considered when choosing from Bond Mutual Funds vs Bonds is the financial infrastructure that might be needed. In order to subscribe to new Bonds and to purchase the Bonds from open market, the investor will need to hold a Demat Account. To trade in the Bonds from the secondary market, the investor will also need to have a Trading Account.

On the other hand, investments in Mutual Fund schemes can be made through a Demat Account, or through a Distributor, or by directly creating a Folio with the Asset Management Company (Fund House). Some Mutual Funds are also structured as Exchange Traded Funds (ETFs), that can be easily traded on the Stock Exchange.

Conclusion

Based on the points that we considered above, it should make inherent sense that both these financial instruments offer different features. The investment decision can be made depending on the factors that are most important for the investor.

It is not necessary that the investor has to pick only one instrument out of Bonds or Bond Mutual Funds. Depending on the investment opportunities available in the market, the investor can even decide to invest in a combination of both Bonds and Mutual Funds.

Disclaimer

This page is for education purpose only

Some information could be outdated / inaccurate

Investors should always consult with certified advisors and experts before taking final decision

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