What is a bond fund & how does it work?

Bond funds are investment vehicles that pool funds from multiple investors to purchase a diversified portfolio of bonds or other debt securities. They offer investors an opportunity to earn regular income through interest payments from the underlying bonds, while also providing diversification benefits. Unlike individual bonds, bond funds do not have a fixed maturity date, allowing for greater flexibility in managing your investments.

What is a bond fund?

A bond fund, also known as an income fund, is a professionally managed investment vehicle that pools funds from multiple investors to invest in a range of fixed-income securities. These typically include government bonds, corporate bonds, municipal bonds, debentures, and sometimes even fixed deposits. Offered by mutual fund houses, insurance-linked plans (ULIPs), and financial institutions, bond funds are designed to deliver steady income, capital preservation, and portfolio diversification.

Bond funds can also be categorised based on investment strategy and maturity profile, such as short-term, medium to long-term, government securities (Gilt) funds, and dynamic bond funds. Each category carries a distinct risk-reward profile, catering to varied investment goals and time horizons. Whether through mutual funds or exchange-traded funds (ETFs), bond funds offer a flexible path to conservative yet strategic investing.

How does a bond fund work?

Bond funds work by pooling money from multiple investors to create a diversified portfolio of bonds. Managed by professionals, these funds typically follow a conservative investment approach, focusing on fixed-income securities with strong credit ratings to minimise risk. The fund manager buys and sells bonds based on the fund’s goals, whether it's stable income, capital growth, or low-risk exposure.

Bond funds generate income through two strategies:

Capital appreciation, by increasing the fund’s net asset value (NAV) as bond prices rise.
Payouts from the interest income earned on bonds.

This structure enables the fund to provide a regular income and potential growth, although the NAV may fluctuate in response to market conditions and interest rates.

Types of bond funds

Short duration funds: These funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 1 year to 3 years.
Medium duration funds: The Macaulay duration of these funds, as per their mandate, is between 3 and 4 years. These funds are suitable for investors with a slightly higher risk appetite and an investment horizon of 3 to 4 years.
Medium to Long Duration Funds: These funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 4 and 7 years. The maturity profile is higher compared to a short duration and medium duration funds. Hence these funds are a moderate-to-high-risk investment proposition.
Long Duration Funds: Here the Macaulay duration of the portfolio is more than 7 years. In a rising interest rate scenario, these funds may expose you to high risk.
Dynamic Bond Funds: These funds have the flexibility to invest in debt securities across maturities based on interest rate scenarios and the macroeconomic outlook.
Corporate Bond Funds: These funds invest a minimum of 80% of assets in high-quality corporate bonds rated AA and above.
Banking and PSU Funds: They invest at least 80% of assets in debt securities issued by PSUs, PFIs and banks.
Credit Risk Funds: They invest minimum of 65% of their assets in low-rated (below AA) corporate bonds. These funds are suitable for investors looking for high risk-high returns.
Gilt Funds: They invest minimum 80% in g-secs across maturity. These funds have zero credit risk as they are backed by the government. However, they are exposed to interest rate volatility.
Floater Fund: They invest minimum 65% in floating rate instruments and less vulnerable to interest rate changes.

Benefits of bond funds

Diversification: By investing in a mix of debt instruments—government, corporate, municipal, and more—bond funds reduce your exposure to the risk of any single bond defaulting. This helps cushion your portfolio from volatility.
Professional management: These funds are managed by experienced fund managers who actively select bonds, monitor credit quality, and rebalance the portfolio for optimal performance and risk control.
Liquidity: Most bond funds offer high liquidity. You can redeem your units at any time, and in the case of ETFs, trade them on exchanges, making it easy to access your money.
Regular income: Bond funds typically pay out monthly interest, providing a steady cash flow that can supplement your primary income.
Tax efficiency: Certain funds, particularly those investing in tax-free bonds, offer tax advantages, making them ideal for high-income investors seeking better post-tax returns.

Tips to choose a bond fund

Define your investment objectives: Whether your goal is capital preservation, generating a monthly income, or achieving long-term growth, ensure the bond fund aligns with your objectives.
Assess your risk tolerance: Consider your comfort level with credit and interest rate risk. Government bond funds are typically safer, while high-yield funds offer greater returns at higher risk.
Review historical performance: Look into how the fund has performed across various market conditions. While not predictive of future performance, it helps understand the fund’s consistency.
Consider the expense ratio: Funds with lower expense ratios generally provide better long-term returns. Compare similar funds for cost-efficiency.
Evaluate fund duration: Understand the fund's sensitivity to interest rate changes. Rate hikes have less impact on long-term funds than on short-term bond funds.
Research the fund manager: A fund manager’s track record and experience can play a significant role in navigating volatile markets and maximising returns.

FAQs

What are the pros and cons of a bond fund?

Pros: Diversification, professional management, liquidity, and regular income.
Cons: Potential for fluctuating returns, management fees, and sensitivity to interest rate changes.

What is a bond fund SIP?

A Systematic Investment Plan (SIP) lets you invest a fixed amount regularly, promoting disciplined investing while benefiting from rupee-cost averaging.

When to buy a bond fund?

Consider investing in bond funds when seeking diversification, regular income, or a conservative investment option, especially during periods of economic uncertainty.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.