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18 Jun 2021

10% return on a Bond Fund and a Bond has a completely different meaning

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A bond that is having a YTM of 10% with a 4-year maturity will give the 10% return if the investor holds the bond to maturity. Here, the bond return is not past return, it is the actual return on the bond based on cash flows from coupon and maturity. Unless the issuer of the bond defaults on interest payments or principal, the 10% return is certain.

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Arjun Parthasarathy

10% return on a bond fund

In conversation with a diligent investor, it came out that he did a lot of homework before investing in a Bond Fund. He studied track record, expense ratios, fund rating and fund returns before investing in the fund. The fund returns were impressive with 10% returns over a one year period and above average returns over a longer term period.

Appreciating his due diligence, which is necessary for any investment, I also wanted to know what was the average maturity and the portfolio YTM. In all his hard work, he did not look at the most important factor in a bond fund, the maturity profile and the portfolio YTM. In this fund's case the YTM was around 6.2% and average maturity was 4 years.

I asked him, will he want to buy a bond that has a YTM of 6.2% and maturity of 4 years and he clearly said no, the return was too low and maturity was too high for him as he expects inflation to pull up interest rates going forward.

The 10% return on the fund was past return largely due to the fact that interest rates had declined sharply post covid but going forward if interest rates increase, the returns can actually come down to below 4% or even much lower if other factors come into play.

10% return on a bond

A bond that is having a YTM of 10% with a 4 year maturity will give the 10% return if the investor holds the bond to maturity. Here, the bond return is not past return, it is the actual return on the bond based on cash flows from coupon and maturity. Unless the issuer of the bond defaults on interest payments or principal, the 10% return is certain.

Of course, the investors needs to do the due diligence on the credit profile of the issuer before investing as the most important factor for generating the 10% return on the bond is the ability of the issuer to service the debt till maturity.

 Is the investor better off in the bond fund or the bond?

In the example mentioned above, it is clear that the bond fund is offering a return of 6.2% over a 4 year period if interest rates stay stable, but if rates increase, returns are much lower. However, if interest rates fall, returns on the bond fund can even be 10%, but the investor believes that interest rates are bound to rise.

If the bond is seen as creditworthy, the investor will get 10% returns on the bond over the 4 years till maturity. Clearly the investor is better off invested in the bond rather than the bond fund.

There are many other considerations that need to go into an investment in bond including liquidity of the bond and taxation, which the investor will have to be aware of before taking an investment decision.

 

INRBonds Quickinvest gives you the best bonds to invest in against taper tantrum.

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