Should you invest in bonds directly or through bond funds?

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Investing in bonds provides an element of stability in an investor’s portfolio. However, bond investing is a difficult exercise for the common investor who needs to understand the various risks associated with it such as credit risk, interest rate risk and liquidity risk.

A key question that an investor who is keen on exposure to bonds has to ask is whether he or she should invest directly in bonds or take the bond fund route?

“If one has the knowledge and skills required for analysing bonds then one can invest directly. Otherwise it is better to go through bond funds. When you invest in bonds funds you get the benefits of research, diversification, better liquidity and convenience,” said Pankaj Mathpal, Managing Director, Optima Money Managers.

Here are a few issues to consider when you have to choose between investing in bonds directly or through mutual funds:

The lock-in factor

When you buy a bond you agree to receive interest payment at periodic intervals. If you buy a long term bond, you lock in the rate of interest for that period of time. On the other hand, when you invest in a bond fund, the fund manager decides for how long to invest the money, in line with the investment objective and permitted asset allocation of the scheme. Hence, bond funds may limit your ability to lock-in rates. The duration of the scheme folio and credit quality may change, as the fund manager’s views on interest rates may change. If you are comfortable with a fund manager deciding on portfolios then you should go with bond funds.

Diversification issue

Limited understanding and limited access to bond markets may keep the scope for diversification limited for individual investors. For example, bonds with low ratings (AA and below) are typically not available for retail investors. Also the ticket size in the secondary market for government bonds is large, limiting retail investors’ access.

A bond fund however, can invest in bonds issued by banks, companies and central and state governments. This helps in diversification and reduces risks.

“For most investors bonds funds would be a preferred choice due to their ability to create a diversified portfolio with a smaller corpus and access to professional management to aid bond selection and reduce potential credit quality events,” said Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors.

Tax advantage

When you receive interest paid on bonds, it gets added to your income and taxed at the marginal rate of tax. This makes it unattractive for investors whose income gets taxed at a higher rate of tax. But investors in low income tax slabs may find it attractive.

However, if you hold your investments in a bond fund for at least three years, then the gains so earned are treated as long term capital gains and taxed at 20 percent after indexation. “The bond coupon is taxable at the slab rate applicable to the investor and hence bond funds may be tax-efficient in the long term if you have an investment horizon more than 3 years.” Mathpal said.

The liquidity issue

If you want to invest in individual bonds do check how quickly you can sell them. Most bonds including government securities are illiquid in the secondary market. When you invest in bond funds, you are assured of liquidity, subject to exit loads. Typically the exit loads are not too high. “Liquidity is is an important factor as most investors tend to use their fixed income exposure as a fall back option, and the ability to liquidate when needed is an important parameter to keep in mind,” Dhawan said.

The cost factor

When you buy a bond in primary issuance, there is no cost. But buying and selling in secondary market incur transaction costs though the costs may not be recurring.

Bond funds also incur such costs. Their expense ratio is a recurring cost which eats into your returns.