Explained: 5 reasons why debt mutual funds work better than direct bond investments

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The Reserve Bank of India (RBI) recently announced that retail investors can buy government securities directly. However, there are several reasons why it makes sense to invest in a debt fund rather than buy bonds from the market.

Funds help in diversification

Many investors underestimate the benefits of diversification. But we have seen how the fortunes of even AAA-rated bonds (for instance Dewan Housing Finance and Infrastructure Leasing & Financial Services) can deteriorate. Or worse, they may default in paying timely interest and  principal. It took a full-blown credit crisis across multiple companies or promoter groups for investors to realise that high yields come with credit risks.

That’s when diversification helps. However, if you buy bonds directly, you may find it cumbersome to assess multiple issuers, even if you have a decent sum of, say, Rs 10 lakh to deploy. But a debt fund can help diversify.

“Typically, an individual’s allocation to an issuer is higher in his portfolio compared to a well-managed bond fund’s allocation to that issuer. In case of default, the loss to the bond fund is relatively lower than the individual,” says Vinayak Savanur, Founder and CIO at Sukhanidhi Investment Advisors.

Says Joydeep Sen, Corporate Trainer (Debt Markets) “While a high net-worth individual can build a diversified portfolio of bonds issued by high-quality issuers, most small investors are better off investing in bond funds to benefit from access to a diversified portfolio and moderate ticket size of investment, as mutual funds accept small amounts as well,”.

Debt funds are more tax-friendly

If you do not require regular monthly income, then investing in bonds brings unnecessary tax liability. Interest from bonds is added to your income and taxed at your slab.

A debt fund works better. You only pay tax when you sell your fund. If units of bond funds are held for more than three years, your capital gains are taxed at 20 percent after indexation. This effectively postpones and reduces the tax burden.

But if you fall in the low income-tax brackets, you can direct bond investments.

Higher investment amount required

Small investors may find it difficult to invest in overnight bonds or government securities due to the larger lot sizes.

“Corporate bonds, especially AA and below rated papers, are complex to assess from a risk-return point of view and rarely available to small investors in India’s debt markets,” says Gautam Kalia, Head-Investment Solutions, Sharekhan.

In a falling interest rate scenario, it pays to invest in long-dated government bonds. For the very short term, you can consider investing in liquid or short duration funds.

Better liquidity

Indian bond markets are extremely illiquid. You might have been tempted to buy a bond with a higher interest rate. But high yield bonds are also lower-rated and therefore less liquid. That’s just a typical scenario. But if the macroeconomic situation worsens, like it did last year due to COVID-19, then such bonds can sink. Many bonds aren’t traded in the secondary market or even if they do, there is a significant discount to the fair value.

Investors in bond funds have assured liquidity at net asset value. Though the Franklin Templeton episode has shaken many investors’ confidence in bond funds on this front, well-managed bond funds from reputed mutual fund houses may still be suitable.

Ease of reinvesting

If you hold multiple bonds and fixed deposits, then you must be getting periodic payments towards interest in your bank account. Keeping track of these receipts is a task in itself. Many a time, such interest received in the bank account stays there unnoticed. Sometimes it gets spent and sometimes it gets deployed at a later date for reasons such as small size of the amount or lack of time to do so. When you invest in a bond fund, all the receipts are redeployed in the best possible opportunities available.

Though investments in bond funds appear beneficial, you cannot ignore the cost associated with them. In a low interest rate regime, the expense ratio of the bond funds – a recurring cost – eats into your returns.