How Bond Funds Work? Meaning, Benefits, Tax Rules & Types

Equity, debt, and cash are some of the major asset classes. Bonds are a type of debt instrument. Debt investments are generally used for short-term goals as they carry relatively lower risk than equity and potentially offer more opportunities than cash. This makes them a unique investment category. If you are looking to explore this space, bond funds can be a good option. Let’s take a closer look so you have the information you need to make an informed decision.

What are bond funds?

Bond funds are closed-ended mutual funds or Exchange-Traded Funds (ETFs) that primarily invest in bonds. These can include government bonds, corporate bonds, municipal bonds, convertible bonds, and other fixed-income instruments.  

What are the different types of bond funds?

Bonds mutual funds can be of different types, as explained below:

• Corporate bond funds: These funds invest in bonds issued by corporations and invest at least 80% of their assets in corporate bonds that are rated AA+ or higher.  
• Government bond funds: These funds invest in government securities.
• Dynamic bond funds: These funds invest across various durations and actively switch their allocation between long-term and short-term bonds based on market conditions.
• Credit risk funds: These funds invest a minimum of 65% in corporate bonds that are rated AA and below. They may carry potentially greater credit risk.
• Banking and Public Sector Undertakings (PSUs) funds: These funds invest in bonds issued by banks and PSUs, with a minimum of 80% allocated to debt instruments of banks, PSUs, municipal bonds, and public financial institutions.  
• Floater funds: These funds invest a minimum of 65% in floating-rate debt instruments. They may also invest in fixed-rate instruments that are converted to floating rates using swaps or derivatives.

Bond funds are also categorised based on the duration or maturity of the bonds they hold. These include:

• Low-duration funds: These invest in short-term bonds and other debt instruments with a Macaulay Duration of between 6 months and 12 months.
• Short-duration funds: These funds have a relatively longer duration. They invest in bonds and other debt instruments with a Macaulay Duration between 1 year and 3 years.
• Medium-duration funds: These funds allocate to medium-term bonds and other debt instruments with a Macaulay Duration of between 3 and 4 years.  
• Long-duration funds: These funds invest in long-term bonds and other debt instruments with a Macaulay Duration greater than 7 years.

Note: Macaulay Duration is the time it takes for the principal amount of a bond to be repaid through the bond’s internal cash flows. For example, say you invest in a bond that has a face value of ₹ 2,000 and offers a 6% annual coupon. The bond will pay ₹ 120 in interest each year. Based on this, it would take around 2000 ÷ 120 = 16.67 years for the bond to repay the principal investment. This is known as its Macaulay Duration.  

In addition to this, there are bond ETFs that invest in a basket of bond securities and are traded on the stock exchange as stocks.

What are the advantages of investing in bond funds?

Here are some benefits of investing in bond funds:

• Diversification: Bond funds help diversify your portfolio. A healthy investment mix includes various asset classes like equity, debt, cash, real estate, gold, and more. Adding bond funds can balance your portfolio and reduce overall risk.
• Stability: Bond funds are relatively more stable and are less influenced by market volatility compared to equities. They offer steady interest payouts, which can help you earn a consistent income over time.
• Potential for wealth creation: Bond funds offer the opportunity to grow your wealth. While their returns may not be as high as those of equity funds, they still offer reasonable growth potential with lower risk. They can be suitable for conservative investors.
• Simplicity of investment: Investing in bond mutual funds and ETFs can be simpler than buying individual bonds. These funds are overseen by professional fund managers, which makes it easier for you to participate.   

How are bond funds taxed?

Bond funds are taxed as debt mutual funds. Their taxation depends on the date of investment.

• Taxation for investments made on or after April 1, 2023

If you have invested in bond mutual funds on or after April 1, 2023, the gains from these funds are added to your total annual income and taxed according to your income tax slab rate. Additionally, there is no indexation benefit.

Note: Indexation benefit allows you to adjust the purchase cost for inflation.

• Taxation for investments made before April 1, 2023

Redeemed between April 1, 2024 and July 22, 2024

If you redeem your bond fund units within 36 months of purchase, the profits are considered short-term capital gains and taxed at your applicable slab rate for the year.

However, if you stay invested for more than 36 months, the gains qualify as long-term capital gains. In this case, you benefit from indexation and the gains are taxed at 20%.

Redeemed on or after July 23, 2024 

If you redeem your unlisted bond fund units within 24 months of purchase, the profits are considered short-term capital gains and taxed at your applicable slab rate for the year.

However, if you stay invested for more than 24 months, the gains qualify as long-term capital gains. In this case, the gains are taxed at 12.5% without indexation benefits.

Note: For listed bond fund units, the required holding period for long-term classification is 12 months instead of 24 months.

What are the risks tied to bond funds?

Here are some risks accompanying bond funds:

• Credit risk: Sometimes, the issuer of the bond may default on paying interest or repaying the principal amount. This is known as credit risk. This risk is especially relevant for bond funds that invest in lower-rated corporate bonds.
• Interest rate risk: Bonds funds can be susceptible to interest rate fluctuations. Bond markets react inversely to changes in interest rates. When interest rates are high, the market value of existing bonds tends to drop, and vice versa.
• Inflation risk: Bond funds may be vulnerable to inflation risk as they may not keep up with rising prices. If bond fund returns are lower than the inflation rate, the real value of your money will wear down over time.

Conclusion     

If you are looking to explore debt funds, bond funds can be a suitable choice. They come in various types, which allow you to align your investments with your financial goals and time horizons. In addition to offering relatively low risk, bond funds provide the potential for stable returns and contribute to portfolio diversification.

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