In terms of asset allocation, fixed income is an essential part of an individual’s investment portfolio. The fixed-income allocation can be made through various financial products, such as bank fixed deposits, government small savings schemes and bonds. As a fixed-income product, bonds offer several benefits, such as regular and predictable income, portfolio diversification, and low volatility. An individual can invest in bonds in two ways: directly or through bond mutual funds. In this article, we will examine the pros and cons of both methods and which one you should choose.
Before we discuss the pros and cons of investing in bonds directly and through bond mutual funds, let us briefly understand the products.
What is a bond?
A bond is a fixed-income instrument that requires an investor to lend money to a borrower and earn periodic interest in return. The borrower is usually a corporate or government (Central, State, Municipal Corporation, etc.). The interest paid is known as the coupon, and its frequency can be monthly, quarterly, half-yearly, yearly, or on maturity. The bond tenure is fixed, and on maturity, the investor is paid the principal back.
An investor can choose a bond based on their risk profile and other factors and map it to their financial goal. The investor has to consider the bond issuer, credit rating, tenure, security, interest rate and its payment frequency, among other factors. Common types of bonds include corporate bonds (issued by various corporate entities) and government bonds (Central Government bonds or G-secs, State Government bonds or SDLs, etc.).
What is a bond fund?
A bond fund is a mutual fund scheme that pools money from several investors and invests it in various types of bonds, based on the scheme’s investment objectives. The scheme builds a diversified portfolio of various bond securities to generate returns for its investors through interest income and capital appreciation. A professional fund manager runs the scheme on behalf of investors.
Each investor is allotted the scheme units in proportion to their investment. An investor can invest a lump sum or make regular investments through a systematic investment plan (SIP). Based on the value of the fixed-income securities it holds, the fund house declares the scheme’s net asset value (NAV) on every business day. The units can be redeemed with the fund house. An investor’s capital gains depend on the difference between the NAV at which the units are bought and the NAV at which they are redeemed.
Now that we understand the meaning of a bond and a bond fund, let us look at the pros and cons of investing in each of them.
Pros of investing in bonds directly
The pros of investing in bonds directly include the following:
Predictable and regular cash flows
When you choose a bond for investment, you know the coupon rate. So, you already know the amount of cash flows that you will get from it. The frequency of interest payments can vary among bonds. Some issuers offer variants of the same bond wherein the interest payment frequency varies.
You can choose a bond with an interest payment frequency that suits your needs. For example, if you are looking for a monthly income, you can choose a bond with a monthly interest payment option.
Option to choose the bond for investment
When you invest in a bond directly, you can choose the type of bond that you want to invest in. You can choose from a secured/unsecured bond, a government/corporate bond, a short/medium/long-term bond, a fixed/floating interest rate bond, etc.
Control over investment
Investing in a bond directly gives you complete control over the investment. You can choose when to buy and sell it.
Cons of investing in bonds directly
Some of the cons of investing in bonds directly include the following.
Higher minimum investment
The minimum investment amount required for some bonds is ₹10,000. Over the years, SEBI has reduced this amount from the earlier ₹10 lakh to ₹1 lakh, and now to the current ₹10,000. However, this minimum amount can still be high for people in the lower-income category.
Concentration risk
With a higher minimum investment amount, it may be challenging for some investors to build a diversified bond portfolio. Hence, these investors will have high concentration risk.
A single default can lead to huge losses
If an investor has a high concentration risk, even a single credit default can lead to a huge loss at the overall portfolio level.
Regular performance monitoring
A direct investor has to monitor the financial performance of the bond issuer, inflation, and the market interest rate scenario, etc. All this takes time and effort on the part of the individual investor.
Liquidity can be a challenge
In the case of some bonds, liquidity can be low. Hence, if a bondholder wants to sell before maturity, finding a buyer can be a challenge. It can also lead to loss of value.
Pros of investing in bonds through a bond fund
In the earlier section, we looked at some of the cons of investing in bonds directly. Most of these can be overcome by investing in bonds through a bond fund. Some pros of investing in a bond fund include:
Access to a diversified portfolio
Based on its investment objective, a bond fund invests its money across various bonds, providing an investor with a diversified portfolio. Diversification reduces the concentration risk an investor can get exposed to when investing in bonds directly. Also, with a diversified portfolio, if one of the bond issuers defaults, it will not affect the overall portfolio much.
Professional management
Every bond fund is run by a professional fund manager. The fund manager is supported by a full-time research team that analyses various bonds on various parameters for investment. So, the investor gets professional management at a fraction of the cost through the expense ratio.
Low minimum investment amount
The minimum investment amount for a bond fund is low, starting from as low as ₹100 or ₹500 for some schemes. The low minimum investment amount is affordable to investors across all income categories.
The investor can also invest regularly through the systematic investment plan (SIP) route. An SIP instils the habit of investing regularly. The investor benefits from Rupee Cost Averaging (RCA) with an SIP. SIP investments are suitable for achieving short, medium, and long-term financial goals.
Easy redemption without liquidity challenge
The bond fund units can be redeemed with the fund house at the prevailing Net Asset Value (NAV). So, the investor can redeem easily without any liquidity challenges.
Cons of investing in bonds through a bond fund
While investing in bonds through a bond fund has several pros, it also has some cons. As the scheme is run by a professional fund manager, the investor has to hand over control. The investor has no say in the portfolio selection and management. As the fund is run professional and incurs certain costs, they are passed on to investors in the form of an expense ratio.
Bond investment: Should you invest directly or through a bond fund?
We have discussed the pros and cons of investing in bonds directly or through a bond fund. Now, let us discuss which option you should choose. Are you a seasoned investor who wants control over selecting the bonds for investment and managing them? If yes, then you may consider investing in bonds directly.
On the other hand, are you a new investor or a busy professional with no time to select and manage bond investments? If yes, you may leave the bond selection and portfolio management to a professional bond fund manager. You may consider investing in bonds through a bond fund. To invest regularly, you may go with the SIP option.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached on LinkedIn.