The current long term debt market crisis in India is leading many readers to ask “should I redeem my bond fund and invest in the individual bonds”. Recently Indiainfoline had raised about Rs. 2000 crores in the market. Likewise Edelweiss had also raised money from the market directly.

So it is a fair question: Should I invest in bonds or should I invest in a bond fund?

A bond can be held to maturity while a bond fund has no maturity date – which is both good and bad. A lot of people have asked me whether individual bonds are safer than bond funds, however, this isn’t exactly accurate. Individual bonds expose you to significantly more individual entity risk – Imagine your mental state if you had invested all your money were invested in Adag, Zee, or ILFS. A constant maturity bond fund is just as safe as an individual bond when it’s held for the right holding period. Unfortunately, the liquidity of bond funds often lures the investor into treating this long-term instrument as a short-term instrument.  When you see the maturity of a bond fund is 3 years you should not invest in it for 2 years. In fact, I’d argue that the ability to see your daily price fluctuations in bond funds significantly increases the behaviorally induced risk of short-termism in bonds. Of course short-termism in equity funds is also a big cause of worry, but the short-termism in bond fund is not really recognized. 

Many people argue that individual bonds are safer because they can be held to maturity, but a bond fund is just the summation of all the individual bonds it holds. So, you’re getting greater diversification by reducing the single entity risk in the portfolio, but because you’re diversifying the portfolio you’re blending the maturity date so that the portfolio is constantly being rolled over across time. While it does not have a specific maturity date it does indeed have bonds maturing inside of the portfolio which means that, if you hold the bond fund for the entirety of the average maturity, your portfolio will mature on average and the probability of you seeing negative returns over that period is very low.  And because you’re more diversified there is a high probability that you’re taking less risk than the individual bonds. Fairly obvious I presume.

We are still worried about the short-termism of some bond funds losing money in Ilfs, Zee, Adag, etc. One has to remember that these are just small portion of the big fund – yes it hurts, but if you had all your money in some such companies you would have lost everything.

I would suggest you invest in ultra short bond funds, PPF, voluntary provident fund, senior citizens savings scheme, as well as bonds of good companies like – Tata Motors, Sbi, Hdfc bank, Cholamandalam. Chola for example is available only in denomination of Rs. 1 Million. So not everybody will be able to invest – but many Hni do invest in these companies.

It is not either or. You can invest in bonds and bond fund. Be very very careful in selecting bonds. In bond fund look for smart and good fund houses. Or good and smart fund house. Depending on your outlook.