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What are Bond Funds?

Bond funds are a type of debt mutual fund that invests solely in bonds. These funds pool money from investors and invest in one form of bond (for example, government bonds) or a mix of bonds such as corporate bonds, municipal bonds, etc. Usually, the investment made in bonds is of high credit quality. However, these funds do not possess any maturity date like individual bonds. 

Each bond fund is managed to meet a specific investment objective. Fund managers are the professionals who manage the mutual fund portfolio. They aim to optimise income and earnings and minimise the credit and default risks of principal and interest payments. Moreover, bond fund investors have two sources of income. One is the capital appreciation which is the rise in NAV over time. The second is the source of income from the interest payment, which is paid as dividends. However, this is dependent on the availability of surplus funds. 

The most common type of bond mutual funds are open-ended mutual funds which are actively managed schemes. It allows investors to buy or sell bond fund units anytime at the Net Present Value (NAV). It is the price per unit of the fund at the end of the trading day. 

Like other mutual fund investments, Bond funds also charge fees and expenses from their investors. However, this fee can differ significantly from one fund to the other. The asset management company determines the expense ratio and other related fees.

Best Bond Funds to Invest in India 2022

The following are some of the best bond funds in India –

Fund NameReturn Since Inception 
Aditya Birla Sun Life Corporate Bond Fund (G)9.1%
HDFC Corporate Bond fund (G)8.3%
SBI Corporate Bond Fund (G)6.8%
ICICI Prudential Corporate Bond Fund (G)7%
L&T Triple Ace Bond Fund(G)7.4%

Types of Bond Funds

The following are some major types of bond funds in India – 

Government Securities Fund/Gilt Fund

These funds invest in government bonds with different maturities issued by the Reserve Bank of India (RBI). The average maturity in this portfolio is between 15 to 30 years. The fund manager actively manages the portfolio and takes duration calls based on the interest rate scenario. However, these funds are susceptible to interest rate movements. It is suitable for investors primarily looking for capital appreciation. Even though the yield on these funds is on the lower side, the risk of default is almost zero. 

Short Term Debt Fund

This fund portfolio invests in a portfolio mix of securities like commercial paper, certificate of deposits and short maturity bonds. The average maturity in this portfolio ranges between 2-3 years. Also, the fund manager employs an accrual investment strategy (hold to maturity) for these funds. Thus, it suits investors looking for short-term investment opportunities with low risk. 

Corporate Bond Fund

These funds invest in securities issued by institutions or companies where the objective is to raise capital. Corporate bonds are also called Non-Convertible Debentures (NCDs). The fund manager aims to invest in high-quality bonds but also invests in lower-rated bonds for additional yield in the portfolio. On average, the fund portfolio majority consists of AAA and AA-rated bonds, and the average maturity ranges from 3-5 years. Also, the fund manager holds these bonds till maturity. However, these funds are subjected to credit risk and default risk of principal and interest payments. It is suitable for investors looking for a slightly higher income than short-term funds. 

Dynamic Bond Fund

These funds invest across the duration, following a dynamic approach regarding security’s maturity in the portfolio. In other words, dynamic bond funds shift their duration of funds based on the market scenario. During the falling interest rate scenario, it shifts to long-duration securities. While in a rising interest rate scenario, it invests in short-duration securities. Thus, this fund aims to provide returns in both falling and rising interest rate scenarios. It is suitable for investors who want to invest in the bond market but do not want to take any decisions on interest rates. 

Income Funds

These funds invest in bonds with the aim of generating regular income. These funds have a portfolio mix of government bonds, corporate bonds and other debt securities. The strategy for these funds is a mix of accrual income and duration. However, these funds are highly volatile in terms of the market interest rate scenario. Therefore, investors must plan their entry and exit into these funds appropriately. It is suitable for investors looking for income and capital appreciation in different interest rate scenarios. 

Inflation Indexed Bond Fund 

These funds invest in inflation-linked bonds or IIBs issued by the government or corporations that are mapped to the prevailing inflation rate in India. The objective of this fund is to generate capital appreciation and income when the interest rates are rising. This fund is suitable for investors who want to hedge their portfolios against inflation and diversify their portfolios. 

Municipal Bond Fund

These funds invest in bonds issued by local and state governments to help fund capital projects. These bonds are attractive because they provide slow and steady income. However, they carry a high degree of risk. 

Who Should Invest in Bond Funds?

Investors looking for portfolio diversification through debt instruments, bond funds are a suitable option. These funds invest in a basket of bond securities, thus offering a diversified investment portfolio. Even though bond funds are not as risky as equity investments, there is a certain level of risk associated with it. Therefore, investors must be aware of the risks associated with bond fund investments. The most common risks with bond funds are credit risk, default risk and interest rate risk. Moreover, it is essential to note that bond funds do not guarantee principal like individual bond investing.

Therefore, investors looking for a well-diversified bond portfolio and having medium to long-term tenure can consider investing in bond funds.

Things to Consider Before Investing in Bond Funds

The following are the things to consider before investing in bond funds – 

Investment Objective

The choice of instrument primarily depends on the investor’s investment objective whether it is short-term or long-term. Therefore, investors must align their investment objective with the bond fund’s investment objective. 

Investment Horizon

The investment horizon is the time period for which the investor wants to hold the investment either short or long term. For instance, short-term funds are for a short-term duration, while income funds are for a long-term duration. Therefore, investors must ensure that their investment horizon aligns with the fund’s average duration or maturity in bond funds. 

Portfolio Diversification

Bond funds invest in different bonds (government bonds, corporate bonds, etc.) as per the investment mandate based on the duration and coupon rate. This means investors can get exposure to the bond market by investing in a single bond fund. However, the minimum limit for every type of bond may vary depending on the type of scheme. Therefore, an investor must check the scheme-related documents carefully. 

Fund Manager

A debt fund manager plays a crucial role as the investing strategy varies depending on the fund type. For instance, a fund manager may invest 80% of its corpus in corporate bonds in the case of a corporate bond fund. Therefore, the fund manager can choose the bonds based on the credit rating and average maturity. Moreover, the mutual fund declares these aspects in the scheme documents. Also, investors must check the fund’s past track record and the fund manager before investing. 

Fund returns

Investors have to study the fund’s historical returns before investing in it. Therefore, assessing the fund’s returns and performance for at least five years is suitable before choosing any bond fund to invest in. Moreover, investors must also analyse the performance during different market cycles to understand how efficiently the fund manager was able to manage the fund. 

Investment Costs

Every bond fund has certain costs associated with it, which are in the form of the expense ratio and exit load. The expense ratio includes the fund management fee, transaction costs, etc., which are charged to the investors through NAV. Thus, this reduces the overall profit for the investors. On the contrary, exit load is a charge that the fund house deducts when the investor exits the fund before a specific time. Therefore, investors must check the expense ratio, which should not be too high while investing in a particular bond fund. 

Financial Ratio

An investor can analyse a bond fund based on performance ratios. These ratios help to measure the performance and compare it with other mutual funds within the category. Some of these ratios are standard deviation, beta, Sharpe ratio, alpha, etc.