What are Bond Funds?

Last Updated: 27 Feb 2023

Investing involves certain risks. There are many options to choose from depending on your knowledge about the instrument you are investing in and your risk-return expectation. mutual fund are a great way to begin your investing journey and diversify your portfolio with minimal effort. Mutual fund managers invest in a variety of stocks/bonds and other instruments to generate average or above-average returns, depending on the risk profile.

A bond fund is a desirable choice for an investor with a low or no risk appetite but has return expectations more than that of fixed deposits and savings accounts. This article discusses what is bond fund in detail.

Bond Fund

A bond fund, popularly known as a debt fund, is a pooled investment product that majorly invests in various types of debt instruments. Bond funds generate relatively stable returns and possess lower risk than equity investing or equity mutual funds A bond fund being a debt-focused instrument generates a monthly passive income in the form of coupons.

According to the bond fund definition, it essentially invests in a pool of fixed-income securities that produce a monthly cash flow. They are a widely used investment vehicle to diversify portfolios with a minimum investment requirement.

Buying a bond primarily means you are lending your money in exchange for a fixed or sometimes floating rate. The coupon rate and the frequency of its payout are mentioned in the bond covenants. There is an inverse relationship between the bond prices and the interest rates. That means bonds trading at INR 995 will have a lower interest rate than a bond trading at INR 990. This relationship between the bond price and the interest rate makes a long-term bond riskier than a short-term bond.

These bond securities collectively in a portfolio of the fund are called bond funds. It differs from the individual bond securities as bond funds do not have a defined maturity date to repay the entire principal amount that was borrowed. A bond fund is more like a mutual fund investing in a pool of bonds or debt instruments, instead of stocks. A fund manager manages this pool of bonds and trades the bond according to the market conditions and rarely holds it until maturity.

Types of Bond Fund

Two major types of entities issuing bonds are-governments and corporates. Bonds issued by these entities can be of different types.

Based on its duration,government bonds fund can be of the following types:

1. Overnight Funds: Debt securities in this fund mature in a day.
2. Liquid Funds: Investing in securities like treasury bills and commercial papers, with a maturity of up to 3 months.
3. Ultra-Short Duration Funds: Macaulay Duration (MD) of the constituent securities are between 3 to 6 months.
4. Low Duration Funds: The MD of debt instruments in this type of scheme is between 6 to 12 months.
5. Money Market Funds (MMF): Cash, treasury bills, and commercial papers constitute the MMF with a maturity of up to one year.
6. Short Duration Funds: Government bonds, debentures, corporate bonds, etc. are part of this fund with an MD of one to three years.
7. Medium Duration Funds: Investing in securities with an MD of 3-4 years.
8. Medium to Long Duration Funds: Constituent debt securities return the principal amount in 4 to 7 years.
9. Long Duration Funds: Securities in this scheme has a maturity of more than 7 years.

Bond funds based on the type of securities in the fund can be of the following types:

1. Dynamic Bond Funds: Fund managers of this scheme take advantage of the prevailing interest rates to generate maximum returns with minimum risk, irrespective of the duration.
2. Corporate Bond Funds: 80% of constituent Securities are the highest-rated corporate bonds.
3. Credit Risk Funds: 65% of corporate bonds in this scheme are below the highest-rated bonds. High-interest rate of a credit risk bond requites for its higher credit risk.
4. Banking and PSU Funds: 80% of the consisting asset are from banks, Public sector Undertakings (PSUs), and public financial institutions.
5. GILT Funds: 80% of securities in a GILT fund are government bonds across different maturities.
6. Floater funds: 65% of constituent securities do not pay a fixed coupon rate. This type of fund is linked to a fluctuating benchmark interest rate like London Inter-Bank Offered Rate (LIBOR). E.g. Coupon rate here would be LIBOR + 2%

Benefits of a Bond Fund

Bond funds are an easy way to diversify your portfolio. Selecting individual bonds and keeping a track of them can be a tedious process. Bond funds give you access to a pool of bonds and an expert fund manager who can take care of this problem. Investing in a bond fund incurs only the cost annual expense ratio compared to the number of transaction costs incurred while purchasing individual bonds.

Discrete bonds can be harder to exit whereas bond funds can be traded anytime at the market net asset value (NAV). A tax-free municipal bond has the potential to generate a higher after-tax yield than a taxable bond fund investment for investors in the higher tax brackets.

Frequently Asked Questions

Why Bond Fund over Equity Fund?

Bond funds are relatively less risky than equity funds. Bond funds combined with equity funds can also provide diversification benefits.

Is Debt Fund the same as the Bond Fund?

Yes, bond funds are also known as debt funds due to their investment in debt instruments.

What is the difference between debt security and a debt fund?

A debt security is the individual bond issued by a company or a government body while a debt fund or a bond fund is a pool of various debt securities.

What is Macaulay's Duration?

The weighted-average time taken to recover the initial price of the bond is known as the Macaulay Duration.