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

Are you looking for a steady and safe investment option, so that you can avoid market fluctuation? If so, then consider exploring bond funds as an investment option. They offer a convenient way to gain exposure to the bond market without the need for expert-level researching, selecting, and managing multiple bonds. Bond funds eliminate the need for individual bond selection and management.

Bond funds have been gaining significant attention recently. In FY23 alone, these funds attracted an impressive INR 1.06 lakh crore¹ in investments, with liquid funds accounting for 60% of the inflow. Such numbers highlight the popularity and appeal of bond funds among investors. Let’s learn more about bond funds and why they are becoming investors’ favourites. 

What Are Bond Funds?

Bond funds are debt mutual funds or exchange-traded funds that buy and sell various types of bonds. These mutual funds pool money from multiple investors to invest in different bonds. Bonds are fixed-income instruments issued by governments, municipalities, or corporations to raise capital. When you invest in such debt funds, you indirectly own a portion of the underlying bonds held within the fund. 

Bond funds typically invest in fixed-income opportunities to generate monthly income for the investor. Usually, short-term bonds yield less interest rate than long-term bonds, but they also have lesser interest rate risk.

What Are The Types Of Bond Funds?

Here are various types of bond funds to invest in:

1. Government Bond Funds

Government bond funds invest primarily in bonds issued by governments or government companies. They involve the least level of risk but also generate a low return on interest.

2. Corporate Bond Funds

Corporate bond funds invest in bonds issued by companies with high credit ratings. Corporate bond funds offer potentially higher returns than government bond funds but come with a higher degree of risk, too.

3. High-Yield Bond Funds

High-yield bond funds are also known as junk bond funds. These funds invest in bonds with low credit ratings. These funds offer you a high return on investment but with a high-risk probability, making them highly susceptible to defaults.

4. International Bond Funds

International bond funds invest in bonds issued by foreign governments or corporations. They provide exposure to global fixed-income markets and can be used to diversify a portfolio geographically.

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.

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.

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.

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.

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 Invest In Bond Funds?

You can invest in bond funds through the following methods:

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. 

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. 

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. Economic Times <https://tinyurl.com/5n986cvy>

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

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Disclaimer: This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip Invest Technologies Private Limited ("Grip", formerly known as Grip Invest Advisors Private Limited) is not registered with SEBI in any capacity and does not advise, encourage, or discourage its users to invest or not invest in any securities. Grip is solely an execution-only platform and does not guarantee or assure any return on investments made by you in any opportunities sourced by Grip and accepts no liability for consequences of any actions taken based on the information provided. Your investment is solely based on your judgement. Investments in debt securities are subject to risks. Read all the offer-related documents carefully.