Mutual Funds Vs Bonds: Learn the key differences
Traditionally while looking for stable and decent returns, people are inclined to invest in instruments such as real estate, gold, Provident Funds, and Fixed Deposits. These instruments, however, sometimes have such low returns that they fail to even protect you from the impact of inflation.
To achieve high returns, investors turn to stocks and mutual funds. While they offer a high potential for wealth creation, periodic slumps in the market raise questions about the consistency of their returns. Bonds fill this space by diversifying a portfolio at a higher return than FDs and Savings Account deposits and lower risk than equity.
What is a Bond?
A bond is a type of debt instrument representing a loan raised by a government or company to achieve a specific financial objective. Here the lenders are the investors who buy the bond, and the borrower is the company or the government issuing the bond.
Terms to know while investing in bonds:
- Maturity Date: The date when the bond’s face value payment is due.
- Face Value: This is the value of the bond at maturity, which is used to calculate the interest payments
- Issue Price: The original price at which the issuer sold the bond
- Coupon Rate: The interest rate on the bond’s face value. It could be calculated monthly, semi-annually, or annually
- Coupon Date: The dates when the issuer makes the interest payment to investor.
- Bond Yield: The return to an investor from coupon payments. It is calculated by dividing the annual coupon payment by the bond price
- Credit Risk: It refers to the risk that the issuer might default and won’t be able to make the interest or principal payments.
Types of Bonds
Bonds can be classified based on the issuer:
Government Bonds are issued by a national, state, or municipal government. Being backed by the government, these are usually very low-risk bonds with nearly zero risk of default.
Corporate Bonds are issued by companies ranging from large-scale corporations to small privately owned start-ups.
Public Sector bonds are issued by Public Sector Undertakings (PSUs). Essentially, PSUs are companies where government undertaking is more than 51%.
Bonds can also be classified based on security against default:
Senior Secured Bonds: These are secured by specific collateral that will be used to pay the bondholders in case of default
Senior Unsecured Bonds: These are not guaranteed by any particular pool of assets. But they have priority of payment to bondholders before other unsecured debt and equity holders
Subordinated Bonds: In case of a default, Subordinated holders are the last bondholders to be paid, just before the equity holders.
Sovereign Gold Bonds: These are substitutes for buying gold in the physical form. One can buy SGBs with different maturities and earn a return over and above the capital appreciation on gold. They also have tax benefits – if held to maturity, the holder is exempted from paying Capital Gains Tax.
Advantages of Bonds Investment
- Bonds are less volatile and risky compared to stocks and MFs. They offer a safer return on investments
- They offer a higher rate of return than saving bank accounts or FDs
- There are bonds with varying periods of maturity. One can choose bonds to match their investment horizons.
- Bonds provide you a safety net. It has been a general market trend that bonds do well when investments such as stocks and real estate—fall.
- Bonds are very useful in offering a predictable source of income. This can be a benefit if you’re looking for security and predictability—for instance a person close to retirement can meet their living expenses with their investment income.
Going ahead, let’s discuss Mutual funds in detail before discussing Mutual Funds Vs Bonds
What is a Mutual Fund?
A mutual fund is a fund that pools money from various investors and is managed by a team of fund managers. The fund is invested in a bucket of stocks, bonds, and cash equivalents. The assets of the fund are chosen around a particular theme. The fund is continuously adjusted as per the performance of the underlying assets.
The amount contributed by each investor is invested in stocks/securities/bonds of the bucket, proportionate to their weights in the bucket. The investor, however, doesn’t have any ownership of the underlying asset. They just own the units of the mutual fund.
Also Read: A Complete Guide on Mutual Fund Investment
Terms to know while investing in Mutual funds:
An Asset Management Company manages the Mutual fund. In India, all AMCs have to be registered with SEBI
Net Asset Value is the price per unit of the Mutual Fund. It is calculated by dividing the value of the entire fund by the number of outstanding units
Growth and Dividend Option: Under the growth option, gains and dividends from the assets are reinvested in the fund, while in the dividend option, they are paid out intermediately as dividends
Exit load: Fee charged by the fund if an investor fully or partially exits a fund within a certain period of investment, known as the lock-in period
A Systematic Investment Plan (SIP) enables an investor to buy fresh units of a fund by investing a fixed amount of money at pre-defined intervals.
A Systematic Transfer Plan enables an investor to transfer certain units from one mutual fund scheme to another scheme of the same fund house. This transfer generally happens periodically.
Types of Mutual Funds
Equity Mutual Funds invest in stocks of different companies as per the fund’s theme, such as Large Cap, Mid Cap, Tech stocks, etc.
Debt Mutual Funds invest in debt instruments such as Government or Corporate Bonds, Money market instruments, etc.
Hybrid Mutual Funds invest in more than one asset class such as equity, bonds, or money market instruments, depending on the fund’s theme.
Advantages of Mutual Funds Investment
- Investment managed by experts: Managing a portfolio of stocks and bonds requires time, knowledge of risks, and returns, which is not easy for everyone. In MFs, one can avail the benefit of experts managing the portfolio with a minimal fee.
- Diversification: Mutual funds consist of securities selected to minimize the risk of all of them performing badly simultaneously. It is a diversified instrument, therefore less risky than investing in a single stock.
- Transparent: All Mutual funds are regulated by SEBI, and their risk profile is demarcated.
- Liquidity: MFs are highly liquid and can be sold within two days
Now let’s look at the differences between mutual funds and bonds.
Mutual Funds vs Bonds vs Stocks
|Bonds||Mutual Funds||Individual Stocks|
|Exposure to risk||Lesser than Stocks and MFs||More than Bonds and less than individual Stocks||Highest risk exposure|
|Returns||Fixed returns which are usually lower than stocks and MFs||Variable returns which are usually higher than bonds. Possibility of loss as well||Highest potential of returns and losses|
|Liquidity||Liquidity is lower||High liquidity||High Liquidity|
|Portfolio Management||Investor is responsible for selecting, buying, and selling the bond||Investor only has to buy or sell a fund’s assets. Experts manage the portfolio’s composition||Investor is responsible for selecting, buying, and selling individual stocks|
|Expense||No extra charges for investing in bonds||Mutual Funds managers charge a management fee||No extra charges for investing in stocks|
While looking at Mutual Funds vs Bonds, we have seen that while bonds offer nearly risk-free fixed returns, Mutual funds come with a potential of high returns at relatively higher risk. Individual stocks beat them both with the highest risk and returns. One must weigh the nuances of Mutual Funds Vs Bonds Vs Stocks against their risk appetite, goals, and investment horizon before choosing the right mix.
FAQs related to Mutual Funds vs Bonds
Can bond investments be made by mutual funds?
Yes. They are called debt funds
How to invest in debt funds?
One can choose the right debt fund by considering the following:
a. Risk appetite
b. Investment horizon
c. Financial goals
d. Exit Load and Expense ratio
One can invest in various Debt Funds via Karvy or CAMS. There are also other platforms where it can be done, such as Coin, ETMoney, and Groww.
What are short-term debt funds?
These are mutual funds that invest in debt with a maturity of 1-3 years. The investors need not have their investment locked in for the same period.
Are bonds safer than mutual funds?
Regarding the risk profile of Mutual Funds vs Bonds, the latter are generally less risky than stock mutual funds. As mutual fund investments are market-linked, they are subject to market volatility. But there are certain risks associated with bonds as well, such as credit risk and inflation risk.
What are the risks involved with mutual funds?
a. Market Risk: losses that can occur due to poor performance of the whole market
b. Concentration Risk: Focusing on one theme. E.g., if you invested only in technology stocks, you would go bust during the dot-com bubble.
c. Liquidity Risk: Excessive selling in mutual funds could lead to liquidity issues for the investors. A lock-in period is introduced to manage this risk.
d. Interest Rate Risk, where a rise in rates can lead to a fall in underlying stock prices
What are the risks of bonds?
a. Risk of default
b. Interest Rate Risk: An increase in interest rates will lead to a fall in the prices of bonds
c. Inflation Risk: Sometimes the coupon rate is less than the prevailing inflation leading to a loss for the investors
d. Liquidity Risk: as the bond market is relatively less liquid
e. Reinvestment Risk where the investor could have to invest the coupon income and principal at maturity at lower rates.
It is important to understand the risks of Mutual funds vs Bonds before investing