Mutual Funds vs. Bonds
- Cambridge Wealth
- Dec 30, 2024
- 8 min read
As an investor seeking risk-averse avenues for your investments, you may have come across bonds and the bond market. In this article, we'll delve into the fundamentals of bonds and bond markets, and compare them alongside mutual funds. By understanding their core differences, you'll be better equipped to make well-informed decisions that align with your personal requirements and risk appetite.
Understanding Bonds and the Bond Market
If you were to lend money to a reliable friend for their business or their development, you would then expect them to return the money with interest after a specific period. Bonds function similarly. The government or corporations issue bonds, essentially borrowing money from investors like you to run their day to day activities, raise capital, and finance their projects. In return, they promise to repay the principal amount (the money you lent) with interest at predetermined intervals. This interest payment is your reward for lending your capital.
What is a Bond?
Think of a bond as a written agreement. It represents a debt obligation between you (the investor) and the issuer (government or company). You purchase the bond at its face value and hold it until maturity, after which, you receive your principal amount back along with the accumulated interest.
A bond is referred to as a fixed-income instrument as bonds pay a fixed interest rate (coupon rate) to its debtholders. If the principal amount is not paid back in full, the bond issuer risks defaulting on their bond payments.
Bond owners are considered debtholders or creditors of the issuing entity. Bond details specify the maturity date when the principal amount of the loan must be repaid to the bondholder. Additionally, bonds outline the terms for variable or fixed interest payments that the borrower is obligated to make to the bondholder over the life of the bond.
Bond prices are invesrsely correlated to interest rates, i.e., when interest rates go higher, bond prices fall. There are multiple reasons for this phenomenon, which are:
Fixed Coupon Payments: Bonds have fixed coupon payments, which means the interest rate is set when the bond is issued. When market interest rates rise, the fixed coupon payments of existing bonds become less attractive to investors, causing their prices to fall to compensate for the lower yield.
Present Value Concept: Bonds are valued based on the present value of their future cash flows (coupon payments and principal repayment). When interest rates rise, the present value of these future cash flows decreases, leading to a lower bond price.
Opportunity Cost: Higher interest rates in the market offer investors the opportunity to earn higher yields on new bond issues. As a result, existing bonds with lower coupon rates become less valuable, and their prices must fall to offer a comparable yield to investors.
Reinvestment Risk: When interest rates rise, investors can reinvest their coupon payments at higher rates, making existing bonds with lower coupon rates less attractive. This reinvestment risk leads to lower prices for existing bonds.
Demand and Supply: When interest rates rise, the demand for existing lower-yielding bonds decreases, while the supply remains the same. This imbalance in demand and supply leads to a fall in bond prices.
The inverse relationship between bond prices and interest rates stems from the fixed nature of bond coupon payments and the present value concept of bond valuation. As interest rates rise, the attractiveness of existing bonds diminishes, leading to a decrease in their prices to compensate investors for the lower yield.
Types of Bonds
Bonds can be classified in several ways, based on various criteria such as issuer, maturity, coupon rate, and convertibility. Here are some common classifications:
Government Bonds:
Sovereign Bonds (e.g., Government Securities or G-Secs): Issued by the Indian government through the Reserve Bank of India (RBI). They are considered one of the safest investment options as they carry minimal credit risk.
State Development Loans (SDLs): Issued by state governments to finance their fiscal deficit. SDLs offer slightly higher yields compared to G-Secs but carry varying degrees of credit risk depending on the financial health of the state.
Corporate Bonds
Public Sector Undertaking (PSU) Bonds: Issued by government-owned companies such as NTPC, ONGC, or SAIL. They offer relatively higher yields than government bonds but are considered safer than bonds issued by private companies.
Private Corporate Bonds: Issued by privately-owned companies across various sectors such as banking, infrastructure, and manufacturing. They may offer higher yields but carry higher credit risk compared to government and PSU bonds.
Maturity
Investors can choose from a range of bond maturities, including short-term, medium-term, and long-term bonds, depending on their investment horizon and risk appetite.
Credit Quality
Credit rating agencies such as CRISIL, ICRA, and CARE provide credit ratings for bonds issued in India, helping investors assess credit risk. Investment-grade bonds (rated AAA to BBB-) are generally considered safer, while below-investment-grade bonds (rated BB+ and lower) carry higher risk.
Tax-Exempt Bonds
Certain bonds issued by government entities such as infrastructure bonds or bonds issued for financing specific projects may offer tax benefits to investors, such as tax-free interest income or tax deductions under Section 80C of the Income Tax Act.
Convertible Bonds
While less common in the Indian market, convertible bonds issued by Indian companies provide investors with the option to convert their bonds into equity shares of the issuing company, offering potential capital appreciation along with fixed income.
Bond Funds
Indian investors can also access bonds through mutual funds or exchange-traded funds (ETFs) that invest in a diversified portfolio of bonds. These funds offer professional management and diversification across various bond issuers and maturities.
Key Features of Bonds
Predictable and Stable Returns: Bonds provide a predictable flow of income through regular interest payments. This makes them suitable for investors seeking stability and a safety net for their capital. Unlike stocks, whose returns can fluctuate significantly, bonds offer a more consistent income stream.
Safety of Capital: Compared to stocks, bonds are generally considered less risky. Government bonds, in particular, are seen as one of the safest investments as they carry the implicit guarantee of the government. This means there's a lower chance of losing your principal investment if you hold the bond until maturity.
Diversification of Risk: While bonds themselves are typically less risky than stocks, they can still contribute to portfolio diversification. Including bonds in your portfolio can help mitigate the overall risk, especially when stock markets experience downturns.
Interest Rates: The interest rate offered on a bond is a crucial factor to consider. It determines the income you'll receive throughout the bond's life and the price at which you can buy or sell it on the secondary market. Generally, bonds with longer maturities offer higher interest rates to compensate investors for the longer investment horizon. However, it's important to remember that interest rates and bond prices have an inverse relationship. As interest rates rise, existing bond prices tend to fall.
Taxation on Bonds
Interest earnings from bonds and debentures fall under the category of 'Income from Other Sources' (IFOS) and are subject to taxation at slab rates. Moreover, if the taxpayer has accrued expenses such as commission, fees, or remuneration related to generating such interest, they are eligible to claim deductions from the interest income.
Conversely, interest income derived from tax-free bonds enjoys full exemption from taxation. Consequently, reporting interest income from tax-free bonds is requisite under schedule Exempt Income when filing the Income Tax Return (ITR).
Table of Taxation on Sale of Bonds
Asset Type | Capital Gains | Tax Rate |
Listed/Unlisted Bonds | Short-Term Capital Gains | Slab rate |
Listed/Unlisted Bonds | Long-Term Capital Gains |
|
When selling bonds and calculating the Long-Term Capital Gains (LTCG) tax in India, you cannot take advantage of indexation. However, there are two exceptions:
Capital Indexed Bonds: These government-issued bonds allow you to benefit from indexation when calculating LTCG.
Sovereign Gold Bonds: Issued by the RBI under the Sovereign Gold Bond Scheme, 2015, these bonds also qualify for indexation benefits on LTCG tax.
What is a Mutual Fund?
A Mutual Fund pools money from multiple investors and invests it in a basket of assets like stocks, bonds, and other securities. A professional fund manager oversees these investments, aiming to generate returns for investors.
There are various types of Mutual Funds catering to different risk profiles. Equity Funds invest primarily in stocks and offer the potential for high returns, but also carry higher risk due to market fluctuations. Debt Funds invest in fixed-income securities like bonds and offer lower risk with predictable, though often lower, returns. Hybrid Funds offer a mix of equity and debt, balancing risk and potential returns.
Additionally, mutual funds provide the option of Systematic Investment Plans (SIPs), which allow investors to invest a fixed amount at regular intervals, such as monthly or quarterly. SIPs help inculcate the discipline of regular investing and benefit from rupee cost averaging, wherein an investor can potentially lower the average cost of their investment by accumulating more units when the prices are low and fewer units when the prices are high.
Key Features of Mutual Funds
Diversification: Mutual Funds spread your investment across various assets, mitigating risk from any single asset underperforming.
Professional Management: Fund managers with expertise handle investment decisions, freeing you from actively monitoring the market.
Variety of Options: Choose a Mutual Fund that aligns with your risk appetite and investment goals.
Potential for High Returns: Equity Funds, particularly over the long term, have historically offered higher returns compared to fixed-income options.
Liquidity: Depending on the type of Mutual Fund, you may be able to redeem your investment quickly (open-ended funds) or face a lock-in period (closed-ended funds).
Systematic Investment Plans (SIPs): Mutual funds offer the flexibility of SIPs, which enable investors to invest small amounts periodically, making it easier to start investing with limited capital.
Mutual Funds vs. Bonds
Area of Consideration | Bonds | Mutual Funds |
Investment Vehicle | Debt instrument issued by governments, corporations, or other entities | Pooled investment in Basket of assets (stocks, bonds, or a mix) |
Risk Profile | Generally lower risk compared to equities, but subject to credit risk and interest rate risk | Varies from low to high risk, depending on the fund's investment objective |
Liquidity | Liquidity depends on bond market conditions and bond type | High liquidity, units can be easily bought or sold |
Management | Self-managed or managed by institutional investors | Actively managed by professional fund managers |
Diversification | Limited diversification, unless invested in a bond fund | Built-in diversification across various securities |
Taxation | Interest income taxable as per applicable tax slabs | Dividend Distribution Tax (DDT) and Capital Gains Tax applicable |
Duration | Bonds are usually held for the long-term | Mutual fund units can be held for the short-term as well as the long-term |
Interest | The principal amount and interest applicable to bonds are fixed | Interest rates are not fixed; dividends are higher when the market performs well |
Losses | Investors receive fixed returns and don't incur losses unless the bond issuer defaults on payment | Investors may incur losses, as mutual fund returns depend on market fluctuations |
Ownership | The purchase of bonds doesn't imply ownership of a company or government | Investors are provided with units of a mutual fund scheme but don't own a stake |
Returns | Bond returns are fixed, and the risks involved are relatively minimal | Mutual funds can provide high returns with greater risks or modest returns with lower risks |
Conclusion
Both mutual funds vs bonds offer distinct advantages and cater to different investment objectives. Bonds are generally suitable for investors seeking a stable income stream and lower risk, while mutual funds provide diversification and the potential for capital appreciation, catering to a wide range of risk profiles. As an investor, it's crucial to assess your financial goals, risk tolerance, and investment horizon before deciding which investment vehicle aligns best with your needs. Remember, investment decisions should be based on a thorough understanding of the underlying instruments, market conditions, and your unique circumstances. Consulting with your financial counsellor for assistance in navigating the investment landscape and building a well-diversified portfolio.
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