There are many different options to invest money. They could be stocks, bonds, real estate and money market funds. The RBI has allowed investors to buy Government securities directly. Retail investors are now allowed to directly purchase government bonds by opening gilt account with it.
Investment in direct bond could or could not be a wise decision as compared to debt funds, given the tax and liquidity advantages from the latter.
The current yield on the 10year government bond (G-Sec) is 6.126% per annum. The yield fluctuates according to the size of the government’s borrowing programme and the RBI’s monetary policy outlook. Those with shorter duration give lower yields.
A debt mutual fund, also known as a fixed income fund, invests in fixed income securities like government securities, debentures, corporate bonds and other money-market instruments. Debt funds make investment keeping in mind the credit ratings of various securities. Debt funds which invest in higher rated securities are less volatile as compared to the low rated securities.
Investment in Debt funds is a viable option and is backed by many reasons.
- Even the highly rated bonds may fail to pay timely interest and principal. They might fetch higher returns but they come with credit risks too.
- While buying bonds it is difficult to assess multiple issuers. This is where diversification becomes necessary. Because mutual funds accept small amount investments, medium to small investors can go for bond funds to gain from diversified portfolio. High net worth investors opt for a diversified portfolio of bonds issued by high-quality issuers.
- The government securities are in large size lots. Small investors might not feel comfortable investing in them. They are even complex to understand from risk-return perspectives for small investors. Long-term government bonds give higher interest. Liquid and short-term funds can be considered for a shorter investment plan.
- Interest income from bonds gets added to the taxable income and is taxed according to the applicable tax slab. If monthly income on a regular basis is not required, bond income creates tax burden. For lower income-tax backets, direct bond fund is suggestible. Whereas in case of a debt fund tax is payable only when the fund is sold. In case of long-term capital gains, benefit of indexation reduces the tax burden. And tax liability arises only after three years, if held for more than that time.
When a listed bond is sold within a year it is taxed at slab rate. For long term capital gains they do not get the benefit of indexation and are taxed at 10% if sold after a year.
- The cost of investment in bond funds is higher compared to the returns it offers.
- Many bonds are not traded in the secondary market, making them difficult to sell at a fair price. India’s bond market is illiquid. High yield bonds are less liquid. As against this, bond funds provide liquidity at net asset value.
- When money is invested in a bond fund, the receipts are reinvested in the most efficient manner possible. In case of many bonds and FDs, bank account is flooded with interest income making it cumbersome to trace them at times. They go unnoticed and get spent and if reinvestment decisions are taken on a later date, the money stays idle in the account.
- Government bonds have almost no risk of default, but the interest rate changes according to the changes in the economy. The longer the duration of bonds, the more sensitive it is to interest rate movements. It might give almost zero profits when returns on bonds are eroded by inflation.