Investing in debt provides much-needed stability to portfolios, especially during times of high volatility in the stock markets. There are two major ways of investing in debt instruments for retail investors. You can either do it yourself or invest through mutual funds which in turn invest the money into their debt schemes. Many investors, however, debate whether the mutual fund route works better for them, or if it still pays to invest directly in bonds. Here is how to assess both these routes:
The accessibility factor
Earlier, purchasing bonds on one’s own was a somewhat difficult process and was considered a prerogative of high-networth individuals. However, in recent years many platforms have emerged that help the common retail investor access a variety of fixed-income instruments. They have emerged as efficient platforms to include bonds in portfolios. While most of them have minimum investments amounting to a few lakhs, some of them like Altifi offer bonds with an investment as low as INR 1,000.
On the other hand, being pooled investment vehicles, mutual funds allow investors to access debt with investments as low as Rs 500. These avenues, unlike traditional bond distributors, might be attractive to a section of investors who do not have a large investible corpus.
In the case of direct investment in bonds, investors may face requirements such as a demat account, while this is not a mandatory requirement for investing in a mutual fund scheme. These may come with a fixed cost, though multiple brokerages provide the option to open a free demat account.
Customizing your needs
Pooled investments, including mutual funds, do not offer customized solutions. There are specific investment mandates that the fund manager has to obey thereby limiting their flexibility. However, when an investor decides to buy a bond directly, he/she can categorically avoid bonds that she is not comfortable with.
An eye on yields
Mutual funds typically manage public money and, in their quest, to mitigate risk and be able to honor all redemptions they avoid investing in high-yield bonds since these are largely illiquid. High-yield bonds in mutual fund holding may make some investors uncomfortable and may deter them since these investments might not find many buyers in the secondary market in the event of sudden redemption pressures. This aspect limits the portfolio yields of the debt mutual fund schemes.
Individual investors looking for higher returns on their debt investment, however, can make an informed decision about investing in select high-yield bonds depending on their risk-taking ability either on their own or taking the help of investment advisors or investing through platforms that offer curated securities.
Also, in the event of panic in the market, debt fund managers have to honor redemption requests, which may suppress the scheme’s returns during adverse times.
However, when an investor decides to invest directly in bonds, she will not be getting impacted due to panic runs and other market anomalies. She can build a portfolio that specifically caters to her needs and decide to liquidate when needed.
Liquidity in mind
Bonds usually have clearly defined maturity and interest payment dates. While buying them investors may be keen to hold on till maturity. However, there are unforeseen circumstances wherein the investor may need money or may spot some better investment opportunities. In such circumstances, the ability to liquidate the investment is a key concern.
In the case of debt mutual funds, the liquidity is assured across open-ended schemes. A sale order placed for debt mutual fund units gets the investor the money within a maximum of three days. However, if the investor has bought bonds directly, she has to identify a seller. In the case of listed bonds, it is relatively less difficult to execute the sell order compared to unlisted bonds. But even for bonds listed on stock exchanges or trading platforms, selling at a fair price may not be easy.
Matching goal and interest payouts
Since bonds pay regular interest and mature on a certain date, they can be used to fund certain financial goals. For example, a regular interest-paying bond may be used to pay recurring expenses. Thus, a monthly payment requirement can be met through bonds providing monthly payout, quarterly obligations using quarterly payout, or yearly renewal premiums using yearly interest payouts. Bonds that offer a cash flow at the time of maturity can be used for specific long-term goals including funding a vacation or the wedding of a family member.
Debt fund investments, however, do not promise any regular returns nor assure payouts. Hence, investors have to sell units after taking into account their needs.
Holding a diversified bond portfolio
Since investments in bonds are not totally risk-free, investing across issuers and maturities are done to mitigate risks such as credit risk and interest rate risk. To achieve this, investors must make the right choice. If one decides not to allocate more than 10 percent of overall debt investment to one issuer, it means there are at least 10 issuers’ bonds held in the portfolio. This calls for effort and understanding of the bond market. Not all individual investors can achieve this since the research and due diligence required before investment may be difficult.
This factor is taken care of through a debt fund. Debt funds are handled by professional fund managers and through their schemes an investor can own a diversified portfolio of bonds where the risk is minimized.
The tax factor (Please note that this is only a generic representation of taxation of bonds and MFs; These can be different on a case-to-case basis; We recommend that you consult your tax or financial advisor before investing)
Interest paid on the bonds is taxed as per one’s slab rate. The gains on the sale of bonds are not subject to indexation benefits. Long-term gains for the sale of listed bonds after holding them for at least one year are taxed at 10 percent. Short-term gains are taxed at a slab rate for directly held bonds.
Gains on the sale of mutual fund units held for more than three years are taxed at a 20 percent rate of tax post- indexation. If the units are held for less than three years, they are taxed at slab rate.
Keeping costs in mind
Mutual funds charge a fixed rate of expense ratio to all investors usually expressed in percentage terms which may range anywhere between 0.3%- 1% of the corpus.
In the case of direct investments these costs are lower as the demat accounts required to hold bonds charge a yearly fee. For large direct investors, the cost as a percentage of the corpus invested would be nominal.
While deciding to invest in bonds, investors should weigh these factors before choosing the path that is best suited for them according to their financial goals and needs.
Team Altifi.