When your business has cash on hand, deciding where to park it can be a challenging task. Both bonds and debt funds offer unique benefits and returns, knowing how each works and who they are best suited for, can help you to make a more informed decision.
In today’s KOFFi Break, let’s understand the key differences between Bond and debt funds. Which one might be the best fit for your needs?
What Are Bonds?
Bonds are debt instruments issued by entities such as governments and corporations. Bonds are fixed-income instruments where, when you buy a bond, you are lending your money to the issuer of the bond (Government / Corporate) at a certain interest rate for a fixed duration.
It’s a common way around the world for companies, municipalities, state governments, and central governments to raise funds for their capital expenditure.
How Bonds Work?
Each bond has a face value (the amount that you will get back at maturity), a fixed interest rate (also known as coupon rate), and a maturity date.
Whenever someone purchases a bond, they receive regular interest payments which are based on the bond’s interest rate. For example, if you have purchased a ₹1000 bond with a 5% interest rate, you would receive ₹50 each year until bond maturity.
So, when the bond reaches its maturity date, the issuer will repay you the total face value amount which is ₹1000 in your case.
What is the objective of Bonds?
The primary objective of bonds is to provide a fixed-income source to the buyer on their money for a long period of time. Let’s try to understand in detail:
- Fixed Returns: The bond issuer (government/company) gives the promise to the bondholder to pay them fixed interest income at regular intervals till the date of maturity.
- Capital preservation: One of the main objectives of fund parking in bonds is to safeguard the principal amount. Bonds are generally considered safer than the stock market, which makes it an attractive option for capital preservation.
- Diversification: Including bonds into a fund parking portfolio can help you diversify risk. Spreading funds across different fixed-income instruments can reduce the overall volatility of parked funds.
Type of Bonds
In India, bonds are classified into various types, based on different criteria such as Issuer, Maturity, Interest Rates, and Convertibility. Here are a few of them.
1. Government Bond: These bonds are issued by the central or state government of India and these bonds are considered the safest investment as they are also referred to as risk-free bonds. There are mainly two types of government bonds:
- Government Securities (G-Sec): These are generally long-term bonds with a fund parking horizon of 5 to 40 years.
- State Development Loans: These bonds are issued by the state government for funding state projects which generally have a fund parking horizon of 3 to 10 years.
2. Corporate Bonds: These bonds are issued by corporations to fund their capital expenditure. These bonds are considered slightly riskier & compared to government bonds. These are further divided into:
- Public Sector Undertaking (PSU) Bonds: These bonds are issued by government-owned corporations, and generally have a fund parking duration of 3 to 7 years.
- Private Corporate Bonds: These bonds are issued by private companies with a fund parking duration of 3 to 10 years depending on credit quality.
3. Tax-Free Bonds: These bonds are issued by the government back entities and the interest income from these bonds is tax exempt from income tax. This means you don’t have to pay income tax on income from the interest of these bonds. These bonds generally come with a fund parking duration of 5-plus years.
4. Zero-Coupon Bonds: These bonds don’t offer periodic interest payments on the principal amount. Instead, they are issued at a discounted face value and redeemed at full face value upon maturity. The difference between the actual face value of the bond and the value of discounted face value represents the investor’s return. These bonds generally come with a fund parking duration of 1 to 5 years.
5. Floating Rate Bonds: The interest is not fixed on these bonds, it may vary based on the bond’s benchmark rate. This means the returns can fluctuate over time. These bonds generally have a fund parking duration of 1 to 7 years.
6. Convertible Bonds: These bonds give investors the option to convert their bonds into a predetermined number of shares of the issuing computer at a specific time. These bonds generally have a fund parking duration of 3 to 10 years.
In general, the majority of types of bonds come with longer fund parking horizons. This means bonds are an appropriate option for those looking for a medium to long parking duration for funds.
Risk Associate with Bonds
Bonds are generally seen as safer instruments compared to stocks. However, they still carry risks that need to be considered.
- Credit Risk: Every bond carries a credit risk along with it. The credit risk is the risk that the bond issuer may default on repayment of the principal amount.
- Interest rate risk: The Bond prices move inversely to the interest rates. Whenever interest rates rise, the bond prices fall and vice versa. This Interest rate risk can affect the bonds market value.
- Liquidity Risk: Liquidity risk arises when an investor is unable to sell a bond quickly without significantly affecting its price. This is more common in corporate bonds, where the market may not have enough buyers or sellers.
Now Let’s try to understand what are debt funds in a similar way.
What are Debt Funds?
Debt funds are the type of funds that only invest in fixed-income securities like bonds, treasury bills, commercial papers, and money market instruments.
These funds are considered lower risk compared to equity funds, as their major assets are allocated into high-quality fixed-income instruments.
How do Debt Funds work?
Debt funds are mutual funds that invest in various fixed-income securities to generate returns.
Investors pool their money together by purchasing units of debt funds. Each unit represents a portion of the fund’s holdings in various debt instruments.
Here are the fixed-income securities where these debt funds invest their money:
- Government Securities
- Treasury Bills
- Corporate Bonds.
- Commercial paper
- Certificates of Deposits
- Money Market Instruments
The NAV stands for Net Asset Value. It represents the market value per unit of a particular mutual fund.
The NAV of all debt funds is published on the respective fund house website as well as the AMFI website daily.
As an investor you can redeem your unit anytime you want, subject to the fund’s terms and conditions. The redemption value is based on the present NAV.
Debt funds typically offer higher liquidity, allowing investors to easily convert their units into cash.
The Objective of Debt funds
The primary objective of debt funds is to provide a way to park your funds in a diverse portfolio of fixed-income securities. Here is a closer look:
- Liquidity: Debt funds typically offer higher liquidity compared to individual bonds or any of their fixed-income securities, which means debt funds allow investors to redeem their funds whenever they want.
- Professional Management: Debt funds are managed by experts who specialize in fixed-income securities, who ensure to make informed decisions on portfolio composition and duration.
- Low volatility: Debt funds are generally very less volatile compared to equity funds, which makes them suitable for risk-averse people.
Type of Debt funds
Debt funds come in various forms, each catering to different objectives, horizons, and risk profiles. Have are the main types of debt funds:
- Overnight funds: These debt funds invest only in those securities that are maturing in one day, typically in money market instruments. These debt funds are idle options for short-term duration.
- Liquid Funds: These debt funds are investing in those securities that have maturity within 91 days. It is also suitable for short duration.
- Money Market Funds: These debt funds are investing in those securities that have maturity upto 1 year. These funds are also suitable for short duration.
- Medium Duration Funds: Those delt funds are invested in securities within 3-4 years of maturity. These funds are suitable for medium duration.
- Guilt Funds: These debt funds are invested in government bonds with a maturity of 5-10 years. These funds are suitable for a long duration.
In general, debt funds are suitable for those looking for fund parking from short to long durations. Even though these debt funds invest in a variety of securities with different durations, they offer high liquidity.
Risks Associated with Debt Funds
Fund parking in debt funds is considered safer than equity funds still it important to know the indirect risk associated with it:
- Interest Rate Risk: When interest rates rise, the price of existing bonds held by the fund falls, leading to potential losses. Higher duration securities come with greater interest rate risk, making the sensitivity to interest rate changes significant for the long term, but not as much for the short term.
- Credit Risk: Credit risk, also known as default risk, refers to the possibility that the issuer of a bond may fail to make timely payments of interest and the principal amount at maturity. This risk is significantly associated with corporate bond debt funds, especially those with higher-duration securities, as they come with higher risk.
Now Let’s try to understand the difference between both of them in a comparative table format:
Criteria | Bonds | Debt Funds |
Objective | Provide fixed interest returns over a specified period | Generate returns through a diversified portfolio of debt instruments |
Diversification | Limited. Typically invest in one type of bond at a time (e.g., government, corporate). | Extensive. Can include a mix of government, corporate, and other types of bonds within the fund. |
Liquidity | Moderate to low. Selling bonds before maturity can be challenging and may incur losses. | High. Debt funds are generally more liquid and can be sold at the current NAV. |
Risk | Generally lower risk, but can vary based on issuer’s credit rating | Risk varies based on the fund’s portfolio; typically moderate |
Professional Management | No. Individual investors manage their bond investments unless they use a professional advisor. | Yes. Managed by professional fund managers who analyze and select securities based on market conditions. |
Complexity (Ease of Use) | Moderate. Requires knowledge of bond markets, interest rates, and credit ratings. | Low. Easier for investors as fund managers to handle the investment decisions. |
Regulated | Yes. Bonds are regulated by financial market authorities (e.g., SEBI in India, SEC in the USA). | Yes. Debt funds are regulated by mutual fund regulatory bodies (e.g., SEBI in India). |
Fund Parking Horizon | Medium to long-term | Short to long-term, depending on the fund type |
Types | Government Bonds, Corporate Bonds, Tax-Free Bonds, Etc. | Overnight Funds, Liquid Funds, Short-Term Funds, Gilt Funds, Corporate Bond Funds. |
Final Thoughts
Bonds are debt instruments issued by governments or corporations that provide fixed interest returns over a specified period, making them suitable for conservative investors looking for stability.
In contrast, debt funds are managed by professionals who invest in a diversified portfolio of debt securities, offering a range of risk and return profiles to suit different investment horizons.
By comparing these options on key criteria such as objective, functionality, risk, investment horizon, and suitability, you can choose the best fit for your business’s financial strategy.
