This time I am talking about something which I learned recently and thought of sharing it with all. The post is related to finance but it is relevant to everyone, as it will be helpful while making investments. This post is about debt funds and basics around it.
What is bond?
A bond is a loan that the bond purchaser or bondholders, makes to the issuer. Like a loan, a bond pays interest periodically and repays the principal at a stated time in future. The “face value” of each bond is typically known as issue price. The bond issuer determines an interest rate, known as the “coupon” and a time duration under which it will repay the principal, known as the “maturity”. The issuer takes into account the prevailing interest-rate environment, to make sure that the coupon is competitive with those on comparable bonds.
What determines the Price of a bond?
Bonds can be purchased or sold in the secondary market after they are issued. Some bonds are listed and traded on the exchanges, while most bonds are typically traded over the counter between large broker dealers either acting for their client or on their own account. When listed on the exchange, a bond’s issue price and yield find its value in the secondary market. A bond’s price reflects the value of the income that it provides through its regular coupon i.e. interest payments. The price of the bond fluctuates in response to different factors like:
– Changes in interest rates,
– Supply and demand,
– Time to maturity, and
– Credit quality / rating
A bond’s yield is the real annual return an investor can expect if the bond is held to maturity. The yield on a bond is based on the price of the bond, the interest payouts and time to maturity. When the interest rates fall, bonds issued in a high interest rate environment become more valuable. Investors holding such bonds can charge a “premium” to sell them in the secondary market. On the other hand, if interest rates rise, those bonds issued earlier during relatively lower interest rate environment may become less valuable because their coupons are relatively low, therefore they tend to trade at a “discount.”
Rising yields can improve a bond portfolio’s return over longer time periods, as the money from maturing bonds is reinvested in bonds with higher yields. Conversely, falling yields, while helpful to bondholders in the short-term, mean that money from maturing bonds may need to be reinvested into new bonds that pay lower rates, thus lowering the returns.
The following comparison can help to explain the difference between Bonds and Debt Mutual Funds:
Return of Principal: In case of Bonds, Principal returned at maturity or when bond is called or put option is exercised, where in case of Debt Mutual Funds Principal could be at risk until its repayment/ redemption.
Maturity Date: In case of Bonds, Maturity date is set at the time of issuance, because in case of Debt Mutual Funds there is no maturity date, unless it is close ended scheme.
Income Payments: In case of Bonds, usually interest payments are fixed and paid semi-annually and annually (except zero-coupon), because in case of Debt Mutual Funds dividends may be declared at specified time intervals in dividend option plans like daily, weekly, fortnightly, monthly, quarterly, half-yearly and yearly. However, dividends are not assured for debt mutual funds and subject to availability and adequacy of distributive surplus at the discretion of Trustees.
Liquidity: Bonds may get traded on the secondary market. but liquidity tends to be low, because in case of Debt Mutual Funds units can be bought and sold at Net Asset Value for open-ended schemes while units of closed end funds are listed on stock exchange and can be bought / sold on the exchange during the tenure of the fund.
Redemption / Repayment: In case of Bonds, Redemption/Repayment only at maturity or when call or put option is exercised, because in case of Debt Mutual Funds units of open-ended schemes can be redeemed at applicable NAV (subject to exit load, if any) on business days. On maturity, units of the closed end scheme get redeemed at applicable NAV.
Default Risk: In case of Bonds, varies based on the credit quality of bond, because in case of Debt Mutual Funds limited due to portfolio diversification.
Interest Rate Risk: In case of Bonds, interest rate risk exists but declines as bonds near maturity, because in case of Debt Mutual Funds interest rate risk exists and sensitivity to interest rates depends on portfolio of holdings and its maturity and payout profile.
Expenses: In case of Bonds, no ongoing expenses except transaction charges built into price for purchases and sales, where in case of Debt Mutual Funds besides annual recurring expenses exit load may be applicable depending on the holding period.
Reinvestment: In case of Bonds, no automatic re-investment option, because in case of Debt Mutual Funds as a market practice, dividend re-investment option is generally available in open-ended schemes.
Professionally Managed: In case of Bonds, there is no professional management, since Debt Mutual Funds are actively managed by professional fund managers.
Diversification: In case of Bonds, need to buy multiple bonds to diversify since in case of Debt Mutual Funds wide variety of bonds are held in the portfolio which can undergo changes based on developments in debt market