What is a Bond Fund?

These funds usually invest in the following:

  • Short-term investmentsShort-term InvestmentsShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons.read more – for those investors with an investment horizonAn Investment HorizonThe term “investment horizon” refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.read more of a year or less.Medium to Long-term investmentsLong-term InvestmentsLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets.read more– for those investors with an investment horizon of 3 or more years.Government securities – for investors with no appetite for default risk and hence considered to be the safest.Bonds are having short-term and long-term maturities, also known as dynamic bond funds.

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How does the Bond Fund Work?

  • After the pooling of investors’ funds, the fund manager in charge invests all the funds obtained in fixed income securities, bonds, etc., as mentioned above, depending on the type of investors forming the pool. Usually, investment is made in established institutions with high credit ratings.The fund’s main objective is to optimize income and earnings and minimize the credit and default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more of principal and interest payments.There are majorly two sources of income for bond fund investors. The first is capital appreciation, which is the rise in the Net Asset valueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity’s liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more over time.The second source of income is dividend income. The dividend is paid out at certain intervals, depending on the surplus funds available.

Example

Let us consider the example of the HDFC Corporate bond fund with the NIFTY Corporate bond index as the benchmark for the fund. The suggested investment period of the bond says 6-12 months. It would be an open-ended scheme investing in moderately risky bonds. The investment pattern would be well-diversified, say investing 80% of the amount of the fund, at the very least, in bonds with a credit rating of AAA and above.

The objective of such funds would be to generate income and expect capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more through such investment patterns.

Types of Bond Funds

#1 – Corporate Bonds

These types of funds invest in corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more. Many further classifications depend on the risk appetiteThe Risk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more and investment-grade variety (based on credit rating).

#2 – Government Bonds

They are the safest type of funds because there is a government guarantee.

#3 – Municipal/Local Authority Bonds

Investment in bonds issued by state governments, local authorities, municipal agencies, etc., shall result in tax exemptionsTax ExemptionsTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more.

Differences Between Bonds and Bond Funds

Advantages

  • From the investor’s viewpoint, these are lucrative compared to bonds because it is easier to partake in bond funds than in individual bonds solely.The transaction costs need not be paid as high as those in the case of individual bonds.Because this fund is a conglomerateConglomerateA conglomerate in business terminology is a company that owns a group of subsidiaries conducting business separately, often in distinct industries. It reflects diversification of operations, product line and market to allow business expansion.read more of many bonds, the impact would be lesser in case of default of payment by one kind of bond.There is an added advantage of diversification wherein even a lower investment would be diversifiedInvestment Would Be DiversifiedA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more, which is impossible in individual funds.Though there is no particular maturity date, the investor can withdraw at any point by receiving the Net Asset Value (NAV).For these, some professionals handle and manage the portfolio that continually analyzes the portfolio.Income generated from bonds is automatically reinvested, and the value of the funds keeps appreciating.

Disadvantages

  • The bond funds, like bonds, react to interest rates prevailing in the market. The lower rate in the market increases the bond demand, and hence the bond price rises. On the contrary, if the interest rate rises, the demand will fall.The fee structure depends on the mutual fund company, its specialization in a particular product, and its regulations.The dividend payments are variable, unlike individual bond interest payments.It may not always be open to all investors. After reaching a threshold or at the fund manager’s discretion, they may close the fund to new investors.

Conclusion

  • These are products offered as mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more ULIPs by pooling all investors’ funds. They may be customized as per the needs of investors. They are suitable for the long-term goals of the investors. This is also suitable for investors who seek diversification.The returns are usually higher than the money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more instruments and deposit rates. They are highly liquid and can be sold at any point in time by an investor, although the fluctuating NAV might seem like a setback.So, if the specialized fee doesn’t seem to be much of a problem, these are best suited for investors seeking income over medium and long terms and those looking for a reasonably stable rate of return with moderate risk.In case of doubts, investors should consult their financial advisors about the product’s suitability.

This has been a guide to What a bond fund is & its Definition. Here we discuss the types of bond funds and how they work, with examples, advantages, and disadvantages. You can learn more about it from the following articles –

  • Bond ETFInternational BondsMeaning of Negative Yield BondGreen Bonds