Bonds and Mutual Funds | Exploring Investment Options for Financial Growth
- Blog|Company Law|
- 5 Min Read
- By Taxmann
- |
- Last Updated on 23 December, 2023
Latest from Taxmann
Table of Contents
- Introduction
- Bonds – Meaning
- Mutual Funds – Meaning
- Types of Bonds for Investment
- Types of Mutual Funds for Investment
- Key Differences between Bonds and Mutual Funds
- Frequently Asked Questions
- Conclusion
1. Introduction
Many a times, investors are confused between investing in a category of Mutual Fund or going for treasury bonds or some other category of bond in the market. Although the returns usually have stark differences between the categories so are the risks of the asset classes. While Equity Class is considered the most risky, the Bond Class is considered the safest among different asset classes.
2. Bonds – Meaning
Bond as the name suggests, is a bond between a lender and borrower where the lender promises to lend a certain sum of money in return of fixed/floating rate of interest and repayment of original amount on a predetermined date. Bond investor is entitled to the interest amount irrespective of how the borrower is performing.
Bonds are a kind of financial instrument that are issued by many entities such as companies, governments, municipalities and many others. The rate of interest associated with the bond decreases as the backing power of the borrower increases. For example, a bond issued by a corporate would have a higher interest rate than a bond issued by the sovereign government because the probability of default of corporate is higher than that of a sovereign government.
3. Mutual Funds – Meaning
Mutual Fund is a collective instrument where many investors come together to create a corpus of money which is then managed by a professional fund manager who manages the corpus to generate superior returns by investing into different securities.
The smallest part of Mutual Fund is called ‘a unit’, the value of which is decided by the Net Asset Value (NAV) method wherein the difference between assets and liabilities of the scheme is divided by the number of units. As the value of investment in securities increase, the NAV of the unit increases thereby giving returns to the investor. Mutual Fund investment is helpful for investors who cannot take out time to research securities and hence provide their money to professionals in return for a fee.
4. Types of Bonds for Investment
There are many kinds of bond available in the market for an investor which can be differentiated on the basis of term of maturity, kind of rate of interest, issuer, etc.
- Term of Maturity: Bonds have different maturities as decided by issuer (borrower) depending upon its needs. Some are short term bonds for a period of 12 months, generally issued by corporates while there are some perpetual bonds where the bond doesn’t mature and keeps paying interest for life, which are generally issued by sovereign governments.
- Kind of Rate of Interest: Some bonds are fixed rate interest-paying instruments that pay the same rate of interest for the life while floating interest rate paying bonds revise the interest rates at predetermined dates as per market situations.
- Issuer: Some types of bonds are issued by corporates while there are other types that are issued by municipalities, institutions or even sovereign governments.
5. Types of Mutual Funds for Investment
The Mutual Funds available can be differentiated on the basis of asset class, investment region, investing style, etc.
- Asset Class: Amongst many available, there are some mutual funds with primary focus of investment in equity market; while others investing in commodities such as gold. There are also mutual funds investing into Real Estate.
- Investment Region: The managers of the corpus invest the monies after extensive research. In case they find a country having more potential for returns, then they focus their investment in that particular country.
- Investing Style: The investment style is unique to every fund manager. Some fund managers take aggressive risk while others not. Thus, the returns might differ even in the same asset class.
6. Key Differences between Bonds and Mutual Funds
|
Characteristics |
Bonds |
Mutual Funds |
| Returns | Fixed return to investor as decided on the date of purchasing the bond. | Return varies with the performance of the investments made by the fund manager and market conditions. |
| Scope of losses | Scope of losses is very minimal in bonds because they are paid first even if the borrower files for bankruptcy. | Scope of losses in very high because the value of investment is highly dependent on market movements and managers decision. |
| Interest | Interest is the only return which the investor gets. It is fixed in nature. | No such thing as interest. The investor gets the return according to how the mutual fund fares. |
| Liquidity | Bonds are traded in stock market but are usually illiquid because of low trading volume. | Units of mutual funds are traded at stock exchanges and are also repurchased by the issuer whenever the investor wants to sell. |
| Risk | Safe asset class depending upon issuer. | Riskier instrument depending upon the investment class. |
7. Frequently Asked Questions
FAQ 1. How do bonds and mutual funds differ in terms of investment structure?
Bonds and Mutual Funds are a bit different in terms of investment structure. When you invest in bonds, you get the bonds directly in your account whereas when you invest in mutual funds you get the units of mutual funds in your account, while the securities in which monies are invested are credited in the account of the Mutual Fund.
FAQ 2. How do bonds and mutual funds differ in terms of diversification?
When you invest in a bond, you just lend the money to a single borrower which leads to undiversified investments. Wheras when you invest in mutual funds, the fund manager invests the monies in many securities hence offering a great diversification.
FAQ 3. Which investment option, bonds or mutual funds, offers greater liquidity?
Mutual funds offer a greater liquidity because they are traded in secondary market and if there are no trades in secondary market, then you can redeem the units to the issuer itself. Same is not the case with bonds.
FAQ 4. Is Mutual Fund a part of Bond?
No, mutual fund is not a part of bond but the reverse stands true because a bond can be a part of mutual fund when the fund manager invests in a bond.
FAQ 5. What are the benefits of investing in a Bond?
- Fixing the interest rate
- Regular cash inflow
- Change in price of bond with respect to market conditions
- Higher position in pecking order in case of insolvency of borrower
FAQ 6. What are the benefits of investing in a Mutual Fund?
- Financial expertise of fund manager
- Diversification
- Liquidity
- Flexible investment value
FAQ 7. Which investments give higher returns to the investor?
The investments which have fared better in terms of giving returns to investors if compared absolutely is the Equity Class. However, this type of measurement approach is incorrect as you can compare investments for better returns only in the same asset class. For example, you cannot compare the return of equity mutual fund and bonds because the risk assumed in both the investment is very different hence return has to be different from each other. Since equity assumes more risk, it has a potential to provide better returns in long term but it can also give negative returns while the bonds provide a healthy interest during the same investment tenure.
Although when we compare the same asset class with same level of risk, bond investment can provide a higher investment return because mutual fund investing in bonds will incur expenses for management fees which impacts the investors’ returns negatively. Hence you can get higher investment return if you invest directly in a bond suitable to your investment period.
8. Conclusion
Thus, when it comes to investing decision, it is a personal choice for investors. Some needs liquidity while others chase risk in order to gain higher returns. Every investment decision should be tailor-made for different investors. Hence, the article is rightly titled with a modification as “Bonds and Mutual Funds. Dono Sahi Hai!”
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