I recently read a newspaper article that recommended that individuals should buy short-term bond funds to meet their emergency requirement. Another article recommended that investment in gilt funds earns higher returns than fixed deposits. Given that the objective of this column is to create discerning investors, we thought it fit to discuss why bond funds, unlike bonds, may not be an optimal investment choice for you!

Bonds were traditionally called fixed-income securities for a reason- they gave you fixed return if you held the investment till maturity. Suppose you buy AAA-rated 11 per cent 10-year corporate bond. You can expect to receive 11 per cent interest a year for 10 years with the return of your initial investment at maturity, unless the company defaults on its obligations. Over the years, fixed-income securities have become very complex but we will restrict our scope of discussion to instruments that offer you fixed rate of interest with a definite maturity.

Traditional fixed-rate bonds should be part of your investment portfolio. Why? Because these bonds have finite life, you need not worry about price declines during the life of the bond. Suppose you bought the 11 per cent 10-year corporate bond in 2012 and price declines in 2013, you can continue to hold the bond till it matures in 2022, at which time you will receive your initial investment amount.

It is important that you choose bonds with maturities that coincide with your investment needs.

That is, if you need money after 10 years, invest in 10 year bonds and so on. Better still, if you do not need the intermediate cash flows in the form of interest, you should invest in accrual bonds or zero-coupon bonds, if available.

These are bonds that do not pay you interest each year. Instead, you receive the entire cash flow only at maturity, similar to the cumulative fixed deposit.

Why not

You can invest directly in corporate bonds. But you should prefer Government bonds because you will have one less worry- whether you will get back your investment at maturity!

The problem is that you cannot invest directly in government bonds. You have to buy gilt funds instead. These are mutual funds that invest only in government bonds. Now, gilt funds are typically open-end funds. This means you can buy and redeem units during any business day directly with the mutual fund.

There is, however, a problem. Your purchase price and redemption price are based on the net asset value (NAV) of the fund. And the NAV is based on the total market value of the fund's portfolio. So, if the bonds in the gilt fund's portfolio decline in value, the NAV will fall as well. Since your return is based on the NAV at redemption and the NAV at the time of purchase, a decline in market price of the bonds will hurt you.

That means you can get lower returns or, perhaps at the extreme, even end-up with losses!

The fact that you are not getting a fixed return on your investment defeats the very purpose of your buying gilt funds!

In other words, bond funds do not provide the “mental liquidity” that bonds do. “Mental liquidity” refers to your indifference to the decline in bond price during the instrument's life because you are confident that you will get back your investment value at maturity!

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at enhancek@gmail.com )

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