Fixed Income: Bonds vs Bond Funds

Bond funds, or income funds, have not been attractive as an investment in the past five years, except in 2008. Like equity funds, there are years when returns from bond funds could be negative too (See Table). If we invest directly in fixed-income instruments and do not trade in them, we do not face this volatility. We enjoy the return which we had calculated while investing. The risks faced by us are of liquidity (not being able to sell when we want to) and one of default (if we are unlucky to be holding a lemon). If we can manage default risk well, liquidity is available on most listed bonds, albeit at varying market prices.

But there is one big difference.  Fixed-income products attract higher income tax. So, even if bond funds gave lower returns, they may be winners if we factor in the tax impact—and not because the fund management has delivered higher returns. When we invest directly, we simply hold the investment till maturity.

Unfortunately, a fund manager cannot do that in an open-ended fund. He has to invest new inflows, sell to meet redemptions and, at the same time, keep an eye on interest rate changes that take market values up or down on a daily basis. Most bond funds have problems in giving a threshold return comparable to that of a fixed deposit, over most periods.

Direct investment in bonds is a good option. There is no deduction of tax at source if one invests in a ‘listed’ bond or debenture. For senior citizens, this could be attractive considering that they enjoy a higher tax exemption limit.

Liquidity is not a major issue and my experience is that, for reasonable amounts (say up to Rs50 lakh), one can find buyers in the secondary markets within three to four working days. Also, as I mentioned in an earlier article, if we do not expect interest rates to rise from here, bonds are good. When the interest rates start to fall, it would normally be possible to sell the bonds in the secondary market at a price higher than what one paid for them.

This could be a good time to enter the fixed-income family—whether it is bond/income funds or gilt funds. It is very unlikely that interest rates will go up from here. And one must get in before interest rates actually decline. It could mean one year or so of waiting but, in case interest rates drop across the board by a couple of percentage points, income funds could deliver more than 15% returns. And this return would be tax efficient compared to direct investment in fixed-income instruments. So far, it has not happened this year due to the very tight liquidity conditions. If we see demand tapering or inflation cooling off, interest rates could fall. If this were to happen in 2012, then it makes great sense to invest now in income funds. In 2008, as interest rates fell, the returns spiked to over 20% for that year!

Of course, no strategy is foolproof. There are two risks to this visualised outcome. One is that interest rates may not change at all, given the tight liquidity and the increasing credit demand. (If interest rates do not come down, it is going to be very difficult to achieve project viability in many infrastructure projects.) Income funds, in that case, would deliver around 7%-9% over one year, which is better than the returns on savings account. The other risk is that interest rates could go up from here, resulting in capital loss. I would rate the risk of this happening as the least of the three (rates remaining static, falling or rising). Hence, in terms of risk-reward, I would not hesitate to move some money into income funds.
 

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