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Within fixed income instruments, there are two main domains investors can explore – individual bonds or debt mutual funds, both of which have their own unique advantages and disadvantages
In this article, we’re going to explore both these investment instruments, learn what they are and how they operate, and refer to a differences table. In that way, we’re going to figure out which investment option is better for which sort of investor.
What are bonds?
A bond represents a loan you provide to an entity, such as a government or corporation. In exchange, the issuer (borrower) promises to repay the principal amount you invested at a predetermined maturity date, along with periodic interest payments. These payments are known as ‘coupons’.
People invest in bonds because they provide a sense of security, since the interest rate you get is directly related to the borrower’s creditworthiness. Worse the creditworthiness of the borrower, the more you get paid for the risk you take with your capital.
That is also the reason why higher-rated bonds (issued by stable entities) come with lower interest rates, while riskier bonds (issued by companies with a higher chance of default) offer potentially higher returns.
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Key characteristics of bonds
- Fixed income: Bonds provide a predictable stream of income through regular interest payments. These help investors create a source of passive income to augment their salary with.
- Maturity date: This defines when you receive your initial investment back (principal). These could be anywhere from a few months to 30 years.
- Credit risk: This is the possibility that the issuer might default on their obligation to pay you regular interest or coupon. Credit risk could also refer to a potential loss of principal paid when the bond was bought.
- Liquidity: Bonds can be traded on the secondary market also, but the price may fluctuate based on market interest rates.
Understanding debt mutual funds
Debt mutual funds pool the money of multiple investors and invest it in a diversified portfolio of fixed-income securities, primarily bonds.
Unlike in bonds where you invest in a company and that’s it, a professional fund manager oversees these funds, strategically selecting bonds based on the fund’s investment objective.
These are generally geared towards the objective of the investor, and could be income generation, capital appreciation, or a balance of both.
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Key characteristics of debt mutual funds
- Diversification: Debt funds spread your investment across various bonds, which bring diversification and reduce risk with the creditworthiness of any one bond issuer.
- Professional management: Experienced and qualified fund managers usually handle bond investment and sale decisions with these funds. You can reasonably expect that these managers will outperform potentially any returns you might aim to gain through individual bond selection.
- Management fees: There is a con, though. Debt funds charge fees to cover operational costs, which might sometimes reduce overall returns compared to directly owning bonds. This depends on a case-to-case basis though.
- Liquidity: Debt mutual funds are generally more liquid than individual bonds since they sell shares in an overall fund, not the bond certificates themselves. If you would like your capital back quickly or on short notice, a mutual fund is more preferred.
Frequently Asked Questions
Yes, debt mutual funds come in various flavours, categorised based on their investment strategy and maturity profile.
Liquid funds: Invest in short-term debt instruments offering high liquidity and low volatility.
Income funds: Focus on generating regular income through investments in corporate bonds and government securities.
Gilt funds: Invest primarily in government bonds, offering high security but potentially lower returns compared to corporate bond funds.
Long-term bond funds: Invest in bonds with longer maturities, aiming for higher potential returns but with greater interest rate risk.
Some debt mutual funds impose exit loads, which are fees charged if you redeem your investment within a specific period (typically within the first year). For actively managed funds with more rebalancing involved, the exit load might be higher. If you’re just investing in Treasuries, find a fund that does it for cheap.
For long-term goals, both bonds and debt mutual funds can be suitable. However, debt funds, particularly long-term bond funds, might offer higher returns due to their exposure to market fluctuations. Since you have a longer timeframe, you can potentially weather these fluctuations and benefit from potential growth.
Debt mutual funds often have lower minimum investment requirements compared to individual bonds, which can be expensive.
When interest rates rise, the value of existing bonds typically falls. This is because new bonds are issued with higher interest rates, making older bonds with lower rates less attractive. This can impact both individual bonds and debt mutual funds that hold bonds. However, the impact might be more pronounced for long-term bond funds, as their holdings are more sensitive to interest rate fluctuations.
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