Difference Between Mutual Funds and Bonds

6 mins read
by Angel One
Mutual funds and bonds are popular investment options in India. They each have their share of benefits and differences. As an investor, you need to know what they are to make informed decisions.

In India, there’s no dearth of attractive investment options for long-term wealth creation. Mutual funds and bonds are among the most popular investments that investors often tend to choose. Despite their common goal, both options have distinct characteristics and satisfy different investment objectives. 

Understanding the difference between mutual funds and bonds can help you make informed decisions that are aligned with your financial goals and risk tolerance. In this article, we’re going to delve deep into the concept of mutual funds and bonds to try and understand what they are and their benefits. 

Fundamentals of Mutual Funds

To truly appreciate mutual funds and their long-term wealth creation potential, it is crucial for you to first understand the fundamentals of this particular investment option. Here’s a deep dive into the concept of mutual funds. 

What are Mutual Funds?

Mutual funds are special investment vehicles that collect money from multiple investors. The pooled money is then used to invest in a wide range of diversified securities like stocks, bonds or a combination of both. Unlike other market-linked investments, mutual funds are professionally managed by experienced fund managers, making them an ideal option for beginner investors with little knowledge about the stock market.

Also Read More About Types of Mutual Funds

Benefits of Mutual Funds in India

Mutual funds offer a plethora of advantages to investors; here’s a quick look at some of the benefits of this unique investment option. 

  • Diversification 

Mutual funds generally invest in a basket of different securities across asset classes and sectors. This diversifies the investment risk and reduces the chances of your investment portfolio taking a hit during adverse market movements. 

  • Professional Management 

Most mutual funds are actively managed by experienced fund managers who make investment decisions on behalf of the investors. They thoroughly analyse the market and actively look out for investment opportunities, a skill that not many investors have. 

  • Liquidity 

Mutual funds are highly liquid investments and can be redeemed at any point in time. However, some funds may levy a fee known as the exit load if you redeem your investments before the expiry of a certain period.  

  • Affordability 

Mutual funds are very accessible to all kinds of investors due to their low minimum investment amounts. You can even invest through a Systematic Investment Plan (SIP), where you can invest as little as ₹500 each month for your desired tenure.  

  • Transparency 

Mutual funds provide regular updates on fund performance, portfolio holdings and expenses, offering a high-level transparency to their investors.

Fundamentals of Bonds

Now that you’re aware of what mutual funds are, let’s look at the fundamentals of bonds before heading over to the difference between mutual funds and bonds

What are Bonds in the Stock Market?

Bonds are fixed-income debt securities that are often issued by companies, governments and municipalities to raise capital. The capital that they raise by issuing bonds is then used to carry out business operations or for developmental activities. 

To put it simply, when you purchase a bond, you’re essentially lending money to the issuing entity. The issuer, in exchange for the funds borrowed from you, pays out interest periodically on the borrowed amount up until a specified tenure. Once the tenure ends, the entity will return the principal amount invested by the investors. 

Benefits of Bonds Investment

Just like mutual funds, bonds also have their share of advantages, let’s look at some of their key benefits before moving on to the differences between bonds and mutual funds

  • Fixed Income Stream

When you invest in bonds, you get a fixed income regularly through periodic interest payments. They can be a good passive income source for investors looking for steady cash flows. 

  • Capital Preservation 

Bonds are far less volatile than equity instruments. This unique characteristic provides stability and protects your capital from losing its value due to adverse market movements. Moreover, bonds come with a promise to repay your principal investment amount on maturity, which provides a level of safety and assurance that many other market-linked securities don’t offer. 

  • Risk Diversification 

Including bonds in your investment portfolio helps you diversify it and reduce the overall investment risk. Bonds typically tend to do well when the equity segment is going through a bearish phase, making it a good alternative investment option. 

  • Hedge Against Inflation 

Some types of bonds, like inflation-indexed bonds, offer protection against inflation by adjusting interest payments depending on the changes in inflation rates. This allows you to always stay on top of inflation. 

Mutual Funds Vs. Bonds: Which is Better?

Before we compare mutual funds vs. bonds to see which of the two investment options is better, let’s check out some of the key differences between the two. 

Particulars Mutual Funds Bonds
Investment Type Pools money from multiple investors and invests in a basket of different securities  Issued by companies, governments and municipalities to raise capital for business operations or developmental activities
Ownership Investors own a portion of the mutual funds’s assets Investors own individual bonds issued by the entity
Management Actively managed by professional fund managers Bonds are not managed by any experienced individual 
Risk Varies depending on the type of mutual fund you invest in  Generally considered to be less risky compared to equity investments
Returns Returns are in the form of capital appreciation and dividend payments Returns are in the form of fixed-interest payments on the invested capital
Liquidity Very liquid and can be redeemed at any point during the investment period Less liquid compared to mutual funds, unless the bonds are actively traded
Fees Expense ratio and exit load are the common charges associated with mutual funds. Brokerage fees and transaction costs are the most common charges associated with bonds.

Now that you’ve seen the differences between mutual funds and bonds, which one should you invest in? Unfortunately, the answer is not straightforward and is based on a plethora of factors, such as your investment style, risk profile and investment horizon, among others. 

For instance, if you’re a risk-aggressive investor with a moderate to long investment horizon looking for high wealth creation potential, you can consider investing in equity mutual funds. You not only stand to benefit from capital appreciation but may also get to enjoy dividend payments from time to time. 

With mutual funds, you get the freedom to choose the type of fund you wish to invest in. In fact, you can even invest in bond mutual funds, provided it satisfies your investment objectives. 

Also, if you’re new to investing and possess very little knowledge or understanding of the stock market, investing in mutual funds may be the way to go since fund managers professionally manage them with decades of experience in the field. 

On the other hand, if you’re a moderate risk taker with a long investment horizon looking for a steady source of passive income, you may consider investing in bonds. The regular interest payments can act as a supplementary income, allowing you to tide over your monthly expenses. Additionally, with certain types of bonds like inflation-indexed bonds, the interest payments are automatically adjusted in line with the prevailing inflation rates. 

Conclusion 

Both mutual funds and bonds are essential components of a well-diversified investment portfolio. Each investment option offers distinct advantages and caters to different investor preferences and objectives. Including both investments in your portfolio is a prudent way to create wealth in the long term. 

FAQs

What is the primary difference between mutual funds and bonds?

Mutual funds are special investment vehicles that pool money from multiple investors and use it to invest in a basket of different securities. Bonds, on the other hand, are fixed-income debt securities that are issued by corporations or the government to raise capital for their operations.

How do mutual funds and bonds generate returns for investors?

Mutual funds primarily generate returns through capital appreciation. That said, some mutual funds also provide returns through dividend payments in addition to capital appreciation. Bonds, meanwhile, offer periodic returns in the form of interest payments and return the principal investment amount on maturity.

What are the costs associated with investing in mutual funds and bonds?

With mutual funds, investors need to be aware of costs such as expense ratio and exit load. With bonds, however, there may be brokerage fees and transaction charges. It’s essential to consider these costs when evaluating investment options.

What factors should investors consider when choosing between mutual funds and bonds?

When choosing between mutual funds and bonds, investors must consider factors like their investment goals, risk profile, investment horizon, liquidity needs and tax implications before making an investment decision.

How liquid are mutual funds and bonds?

Mutual funds are generally very liquid and can be redeemed at any point in time. With regard to bonds, however, not all of them enjoy the same level of liquidity as mutual funds. In fact, there are a few types of bonds that have low liquidity since they’re not as actively traded.