When it comes to investing in the stock market, there are several types of assets from which investors can make their pick. Among them, mutual funds and bonds are the most common avenues in which investors usually prefer allocating their capital depending on their risk appetite.
If you are a new investor, choosing any one among these two assets can be a difficult task. In this regard, you should consider making a choice depending on your investment objective and risk tolerance level. To assess these factors, it is important for you to know the differences between the two.
So, let’s dive deeper into bonds vs. mutual funds in order to help you decide.
What are Bonds?
Bonds are debt securities that are usually issued by governments, corporations, companies, etc., to raise money from investors (bondholders). You can think of them as a loan which these entities take to fulfill their capital requirements. They are taken for a fixed period of time, and the issuer pledges to pay interest to the investors along with the borrowed capital.
Thus, bonds are known as fixed-income investments. They generate stable returns throughout their tenures in the form of interest or coupon payments. Thus, they are suitable for risk-averse investors who are looking for portfolio diversification with debt-based securities.
What are Mutual Funds?
Mutual funds are investment vehicles which pool money from investors in order to invest in securities like equities, debt instruments, commodities, money market instruments, etc. The funds have a fund manager who actively manages the assets to provide the highest possible returns to investors.
When you invest in a mutual fund, you get units based on the amount of money you put in and the Net Asset Value (NAV) of the fund. The value of a mutual fund scheme is denoted by its NAV per unit. You can redeem the units at any time, depending on your investment objective.
Types of Bonds for Investment
Here are the various types of bonds which investors can find in the market:
- Government Bonds
Government bonds are debt instruments issued by government authorities. Being government-backed, they have less chance of default. Thus, they are classified as very low-risk bonds and are suitable for investors with low-risk appetites.
- Treasury Bonds
Treasury bonds are issued by the US Federal government and have a maturity period of 10 to 30 years. They have very low credit risks and provide interest payouts at a fixed rate, depending upon the market conditions.
- Corporate Bonds
As the name suggests, corporate bonds are issued by companies to raise capital for funding their operations. The interest rates and tenures of these assets depend upon the issuing organization’s creditworthiness, thus making them riskier than government or treasury bonds.
- Sovereign Gold Bonds
These bonds are issued by the RBI on behalf of the government of India. These securities are denominated in grams of gold and are one of the safest modes of investments in the country as they are backed by the Indian government. It is an alternative to physical gold and also lets the investor earn interest income on it.
- Fixed Rate Bonds
Fixed-rate bonds are assets that provide interest income to investors at a stable rate throughout their tenures. They are perfect for investors who want predictable returns despite the ongoing market conditions.
- Floating Rate Bonds
In case of floating rate bonds, the interest rate tends to periodically change throughout the tenure. It is based on a set benchmark rate, and the change may take place annually, semi-annually or quarterly, depending upon the issuer. These assets are suitable for investors who want to protect their holdings against interest rate risks.
Types of Mutual Funds for Investment
Some of the popular types of mutual funds which investors can opt for are as follows:
- Equity Funds
Equity funds primarily invest in shares of companies with the objective of capital appreciation. They can be further subdivided into small-cap, mid-cap, large-cap, multi-cap and sectoral/thematic funds. These schemes are best suited for those investors who aim to generate higher returns over a long term investment horizon.
- Debt Funds
Debt funds or bond funds are schemes which predominantly invest in debt securities like bonds, debentures, treasury bills, commercial papers, etc., in their asset portfolios. They are comparatively safer in comparison to equity funds and are suitable for regular income generation.
- Hybrid Funds
Hybrid mutual funds have an asset portfolio consisting of more than one asset class. They usually invest in equity and debt instruments, or even commodities, to provide diversity to their investors. The investment objective of these schemes is to strike a balance between regular income as well as long term capital appreciation.
- Money Market Funds
Money market funds are schemes which invest in high-quality short-term debt assets and cash equivalents with a maturity period no longer than 13 months. They have lower risks in comparison to other types of mutual funds as the fund manager has the liberty to adjust the investments as per the risk associated.
- Index Funds
The investment objective of index funds is to generate similar returns to major stock market indices. They are passively managed schemes in which the asset allocation is based on the index upon which the fund is based. These funds usually have lower expense ratios and are a great choice for investors who wish to reduce risks by diversifying their portfolios.
- Exchange-traded Funds
Exchange-Traded Funds (ETFs) are schemes which invest in numerous assets like stocks, bonds, commodities, securities present in a particular index, etc. Their units are tradable on stock exchanges, providing investors with the benefit of trading and placing limit or stop-loss orders.
Key Differences Between Bonds and Mutual Funds
Here’s a comprehensive take on bonds vs mutual funds:
|Can be bought or sold at any time in the secondary market.
|Fund units are tradable during market hours. However, some may have a lock-in period.
|Interest is applicable at a fixed or floating rate on the principal amount, based on the bond type.
|Interest rate is applicable depending upon the securities in which the fund invests.
|Risk depends upon the issuing authority’s creditworthiness, while returns are based on the interest rate and maturity value.
|Both factors depend upon the underlying asset’s performance.
|Fixed income assets with face value, bond coupon rate, maturity date and yield.
|Securities like equity, debt assets, commodities, etc.
|Offer sectoral diversification depending upon the issuer.
|Provide high portfolio diversification based on the fund type.
|Managed by the issuing entities.
|Managed by the fund manager of the Asset Management Company (AMC).
Which Investments Give Higher Returns to the Investor?
If you are planning to invest in bonds and US stocks, knowing which asset type can provide higher investment returns is essential. If generating high returns is on your mind, the simple answer to this question is mutual funds.
Such schemes are managed by financial experts who aim to generate market-beating returns for their investors. Moreover, by investing in mutual funds and ETFs, your portfolio gets exposure to several asset classes, thus diversifying risks.
However, returns should not be the only thing you should consider while choosing between these two assets. You must also keep in mind your risk appetite.
In this case, bonds facilitate returns at a fixed/floating rate over a long-term horizon. Thus, short-term price fluctuations will not affect returns, thereby minimizing risks. Additionally, if you are investing in US Treasury Bonds, their returns are guaranteed by the US Federal government and have a very low risk of default.
It should be noted that Indian investors cannot invest in US treasury bonds directly. However, they may invest in US treasury bonds through publicly traded ETFs.
To sum it up, when it comes to bonds vs. mutual funds, your investment objective must be the final determining factor. Investing in US bonds is a better alternative for risk-averse investors, but if you are willing to take the risk for a greater return, you can go for mutual funds.
Frequently Asked Questions
How do bonds and mutual funds differ in terms of investment structure?
Bonds are debt securities issued by governments and companies to raise capital for funding their operations. Alternatively, mutual funds are schemes having sponsors, trustees and asset managers who invest in various securities to facilitate capital appreciation for investors.
How do bonds and mutual funds differ in terms of diversification?
In case of bonds, diversification comes from the issuers who belong to different sectors like government, credit, mortgage, non-US, cash, etc. Whereas, for mutual funds, the diversity comes from portfolio allocation in various assets like stocks, bonds, money market instruments, treasury bills, etc.
Which investment option, bonds or mutual funds, offers greater liquidity?
When comparing bonds and mutual funds in terms of liquidity, the latter is the better investment option. You can sell bonds in the secondary market, but the trading volumes are usually very low. But, in case of mutual funds, you can redeem your units at any given point in time. However, you need to consider the exit load and tax implications.
Are mutual funds a part of bonds?
No, mutual funds are investment vehicles that have several asset classes in their portfolios. One such asset class can be debt securities, such as bonds, depending upon the fund manager’s investment objective.
What are the benefits of investing in bonds?
Some of the benefits of investing in bonds are safe and predictable returns, attractive interest rates, portfolio diversification and accruing capital gain. Moreover, you can use government bonds as collateral for availing credit at certain banks and other financial institutions.
What are the benefits of investing in mutual funds?
Mutual fund investing benefits consist of low minimum investment amounts, fund management by financial experts, high liquidity and long-term capital appreciation.