Understanding Bond Funds: How They Work, Benefits, Tax Considerations And Types

India’s debt market has quietly bucked a global pattern. While rising yields have unsettled investors in major economies, India’s bond environment has stayed calm, supported by moderate inflation and a more accommodative monetary policy. 
In April alone, domestic firms secured nearly INR 987 billion through bond issuance1. These conditions have made bonds an appealing option for both companies seeking capital and investors looking for steady returns. 
For those observing this activity from the sidelines, there is now a structured avenue to engage with these developments, that does not require buying individual bonds. 

In this blog, we will explore bond funds in India and explain how do bond funds work, who it is for, and what you should know before considering it.

What Are Bond Funds?

Bond funds function as pooled vehicles where investor capital is deployed into income-generating debt holdings. These vehicles may include instruments issued by governments, public sector undertakings or private corporations, depending on the strategy in place.
For instance, take the HDFC Corporate Bond Fund. 80% of its portfolio is composed of corporate bonds rated AA+ or higher.
Rather than holding a standalone debt security, the investor owns a stake in a dynamically managed portfolio. This collective structure introduces variety and reduces reliance on the performance of one issuer.
Oversight rests with fund managers, who make decisions on:

1. Assessing macro and sector-specific cues to construct a mix of bonds to prevailing return profiles
2. Reviewing portfolio stance to shifts in monetary policy, inflation trends or credit ratings that warrant tactical revisions
3. Strategically reinvesting proceeds from maturing or sold securities that complements the portfolio’s intended risk-return contour.
The vehicle is commonly structured and distributed by asset management entities, unit-linked insurance products and certain regulated financial intermediaries.

What Are The Types Of Bond Funds?

Here are various types of bond funds to invest in:

Bond funds are not all alike. Each category follows its own strategy, shaped by duration, credit focus and macroeconomic sensitivity.

Some key classifications include:

1. Corporate bond funds concentrate on debt instruments from private sector entities.

2. Government bond funds focus on sovereign securities, typically favoured for their stability and liquidity.

3. Dynamic bond funds remain flexible, adjusting exposure across maturity profiles and credit tiers in response to market signals.

4. Credit risk funds hold lower-rated instruments that may generally offer elevated yields in exchange for higher default risk.

5. Banking and PSU funds revolve around bonds from banks and public sector undertakings.

6. Floater funds incorporate instruments whose coupon resets periodically, offering potential insulation against policy rate shifts.

7. Duration-based funds are classified by holding period:

• Low and short duration funds typically invest in shorter-term securities with minimal rate sensitivity
• Medium and long duration funds extend into longer maturities, which may amplify return variability.

Each type reflects a specific stance such as interest rate direction, credit appetite and liquidity preference. Understanding these nuances is central to informed allocation.

Why People Invest in Bond Funds

Fixed-income investment options are drawing greater attention in India’s changing investment ecosystem. With traditional bank deposits offering modest gains and equities exhibiting episodic volatlity, bond-oriented schemes present a structured middle path that resonates with a broad spectrum of savers.

The bond market itself has grown substantially. From INR 4.4 trillion in FY2015, gross issuances are projected to reach INR 11.2 trillion by FY2025, reflecting a nearly decade-long compound growth2. Digital bond platforms by SEBI have further facilitated wider participation, especially among non-institutional players.

When comparing bond funds vs fixed deposits, the distinction lies not only in returns but also in structure and flexibility.

Fixed deposits, which typically yield around 7%, offer capital safety but limited growth. In contrast, bonds, particularly those invested in well-rated corporate instruments, can generate annual returns ranging from 8-15%, depending on the credit profile and market conditions3. 

What also sets bond funds apart is the shift in risk character. Instead of riding equity-linked volatility, they reorient exposure toward interest rate shifts and issuer reliability, thereby offering a distinct diversification layer within the portfolio.

In the attractive bond market, here are the reasons why people invest in bond funds:

• Enable structured participation across varied durations and issuer categories
• Avoid lock-in constraints through open-ended formats
• Align with distinct investor profiles through differentiated credit exposure
• Improve visibility into underlying risks via regular portfolio disclosures and public credit data
• Support income consistency while maintaining strategic capital allocation.

How Do Bond Funds Work?

Investing in Bond funds is like joining a collective investment club. When you invest in a bond fund, the fund managers pool money collected from you and other investors. They use the pooled money to then strategically invest in a diversified portfolio of bonds. Later, they carefully select a diversified portfolio of bonds to reduce the risk associated with any individual bond defaulting. 

Additionally, once the fund's portfolio starts generating income from regular interest payments, this interest is distributed among investors like you, providing a source of income.

What Are The Advantages Of Investing In Bond Funds?

Here are certain benefits of investing in bond funds:

Diversification

Bond funds allow you to invest in multiple bonds. Investing through bond mutual funds allows you to spread your risk across various sectors with varying maturities. This diversification can reduce the impact of default by any individual bond.

Accessibility

Bond funds provide access to the bond market with relatively lower investment amounts. It is much cheaper than purchasing individual bonds. This makes them accessible to a broader range of investors.

Liquidity

Bond funds are generally more liquid than individual bonds. This allows you to buy or sell bond funds on any business day at the fund's current NAV.

What Are Risks And Considerations Associated With Bond Funds?

It is important to consider the risk factors before investing in bond funds. This will help you determine the best bond to invest in and balance your portfolio return. Following are the different risk factors that you should assess before investing in these funds.

1. Market Risk

Bond funds are dependent on market volatility. Changes in market conditions and economic factors can impact bond prices and the fund's performance.

2. Management Risk

The potential of a bond fund is influenced by the decisions of the fund manager, especially in bond mutual funds. Hence, inadequate management or poor investment decisions can negatively affect the returns of the fund.

3. Credit Risk

Bond funds are exposed to the credit risk of the various bonds in which investment has been made. Thus, if the bond issuer in the fund defaults or faces financial difficulties, it can affect the fund's value. It is advisable to invest in those bond fund managers that purchase “AAA” or “AA” credited bonds as they are highly unlikely to default.

4. Cost of Investing 

Managers of debt mutual funds charge a fee for providing these services, which results in lower returns. As an investor, you must look at the cost you are paying and the impact on your returns.

How To Choose Best Bond Funds To Invest In 2025

Selecting a bond fund within the dynamic framework of the best conservative investment options in India calls for deliberate evaluation. The following factors can help guide an informed selection process.
1. Check Maturity Profile
Funds are built around different maturity patterns, each responding differently to shifts in borrowing costs. Shorter maturity profiles typically experience less price volatility, while longer-dated securities tend to carry higher return potential but with increased risk. Align this with your financial goals and your positioning of risk.
2. Look at Past Performance
Rather than focusing on a standout year, examine how the strategy has adapted across contrasting market events. A consistent trajectory across different cycles suggests underlying strength, not merely favourable timing.
Below are examples of bond fund returns in India as of June 25-2025, providing a reference point for how various funds have performed across different durations and credit categories. 

3. Know the Credit Rating
Credit quality within the fund’s holdings directly affects its resilience. A credit rating, assigned by independent agencies, reflects the assessed ability of an issuer to meet scheduled payments.
Instruments rated at the higher end of the spectrum generally reflect lower default probability. By contrast, portfolios leaning on sub-investment-grade may seek higher yield at the expense of elevated credit exposure. Understanding where the portfolio sits on this spectrum is key to assessing durability under stress.

How To Invest In Bond Funds?

You can invest in bond funds through the following methods:

1. Direct Investment With Mutual Fund Companies

Mutual fund companies in India offer bond funds. You can invest directly by visiting their website. They will guide you through opening an account, completing documentation, and investing in bond funds. 

2. Online Investment Platforms

Online platforms make it easy to invest in bond funds. You can browse and select from various bond funds offered by different companies. It is important that you compare the performances of various bonds and choose a fund that has been generating a steady rate of interest over the years. 

3. Mutual Fund Distributor

You can invest through financial intermediaries such as banks or brokers. They can understand your financial goals, how much risk you can handle, and your investment preferences. Based on this information, they can recommend bond funds that are right for you. 

What Are The Tax Considerations Related To Bond Funds?

You need to be aware of the tax implications associated with bond funds. The tax considerations² related to bond funds involve capital gains on your income and the taxation of these gains at your individual slab rate.

The Bottom Line

Bond funds offer an attractive investment option for diversifying your portfolios and earning passive income from the fixed-income market. Nonetheless, it is essential to carefully assess the risks involved before investing in any bond fund and choose a fund to invest in that aligns with your personal financial goals. It is important to consider the market risks and credit ratings of the bonds that the fund invests in. This will help you choose the best bond fund to invest in.

If you want to explore high-yield bonds for your portfolio, explore Grip Invest today. The platform offers high-quality corporate bonds from leading NBFCs in India that can help you balance your portfolio returns.

References

1. Reuters, accessed from: https://www.reuters.com/world/india/india-file-sheltered-bond-market-storm-2025-05-28/

2. The Wire, accessed from: https://m.thewire.in/article/economy/the-state-within-indias-corporate-bond-market

3. The Economic Times, accessed from: https://economictimes.indiatimes.com/markets/bonds/why-bonds-belong-to-every-indian-investors-portfolioand-why-now-is-the-ideal-time-to-invest/articleshow/120337864.cms?from=mdr

4. The Economic Times <https://tinyurl.com/5n7hznhd>

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