What is a Bond Fund? Benefits & How it Works?

India’s debt market moves in cycles. When the government borrows more, bond supply rises. And, when the Reserve Bank of India changes policy rates, the yield across government and corporate bonds adjusts.

These shifts do not remain confined to institutions and directly influence mutual fund portfolios, fixed-income returns, and investor decisions. In this setting, understanding how bond-oriented schemes function is not optional but essential.

But what is a Bond Fund? Read further to know the meaning, how it works, tax implications, risks, and much more!

What is a Bond Fund?

A bond fund is a collective investment vehicle (mutual fund or ETF) that allocates capital to fixed income instruments such as government bonds and corporate debentures. The objective is income generation and capital preservation, subject to existing interest rates and credit conditions.

In practical terms, the fund aggregates investor capital and deploys it across a portfolio of debt instruments. The income earned from coupon (interest) payments forms one component of return. The second component arises from changes in bond prices, which fluctuate in response to interest rate movements, inflation expectations, and monetary policy decisions, particularly those of the Reserve Bank of India.

How does a bond fund work?

Bond funds convert the bond market movements into managed, tradable investment units for income-oriented investors.

• Diversification & market access: Through the aggregation of capital, the fund secures participation across government, corporate, and municipal bonds, thereby limiting issuer-specific risk within the portfolio.
• Active portfolio management: The fund manager allocates holdings in accordance with interest rate expectations, credit assessments, and yield curve positioning, rather than passively retaining securities until maturity.
• Income accrual & distribution: The interest generated by the underlying instruments is collected within the scheme and distributed to unit holders at prescribed intervals, subject to the distribution policy.
• Net Asset Value (NAV) mechanism: Unlike individual bonds with defined maturity and repayment, bond funds remain open-ended, and their unit price fluctuates daily according to the current market value of portfolio holdings.

Example of Bond Fund

Let’s take the example of the HDFC Corporate Bond Fund, an open-ended debt scheme that invests in high-rated corporate bonds. As per its stated mandate, a minimum of 80% of total assets is allocated to instruments rated AA+ and above.
The portfolio comprises debentures issued by large financial institutions, public sector undertakings, and established corporations. And, its performance is benchmarked against the NIFTY Corporate Bond Index, and returns are driven by accrual income along with mark-to-market adjustments arising from interest rate movements.

Types of Bond Funds

Bond funds in India are classified by investment mandate, maturity profile, and credit quality, in accordance with categories defined by the Securities and Exchange Board of India. Each category reflects a distinct interest rate sensitivity and credit framework.

Overnight Fund	These invest in securities with a maturity of one day, and are designed for capital preservation with minimal interest rate risk.
Liquid Fund	These allocate capital to money market instruments with maturity up to ninety-one days, and are used for short-term investing of surplus funds.
Ultra Short Duration Fund	These maintain portfolio duration between three and six months, and have moderate sensitivity to rate movements.
Low Duration Fund	Investment in instruments with portfolio duration of six and twelve months.
Money Market Fund	The focus is in money market securities with up to one year of maturity.
Short Duration Fund	These maintain portfolio duration between one and three years, balancing accrual income and rate risk.
Medium Duration Fund	Investment in securities with three and four years of duration.
Medium to  Long Duration Fund	These maintain duration between four and seven years, reflecting higher sensitivity to rate cycles.
Long Duration Fund	Investment in instruments with duration exceeding seven years. The performance is influenced by interest rate trends.
Dynamic Bond	These operate without a fixed duration band, and adjust duration in response to rate expectations.
Corporate Bond Fund	Investment of minimum 80% of its total assets in highest rated corporate bonds, usually AA+ and more.
Credit Risk Fund	Investment of minimum 65% of total assets in corporate bonds rated below AA+.
Banking and PSU Fund	Investment of minimum 80% of its total assets in debt securities issued by banks, public sector undertakings, and public financial institutions.
Gilt Fund	Allocation of not less than 80% of the total assets to government securities across varying maturity periods.
Gilt Fund with 10 year constant duration	Allocation to government securities with the portfolio duration maintained close to ten years.
Floater Fund	Allocation of not less than 65% of the total assets to floating rate debt instruments.

Bond Fund Benefits

Bond funds offer the following benefits to the investors:

• Income accrual: The primary source of return is the accrual of interest from the underlying debt securities. This income forms the base layer of performance across most duration categories.
• Risk distribution: By holding a portfolio of instruments across issuers and maturities, the fund mitigates concentration risk that would otherwise arise from ownership of a single bond.
• Professional portfolio management: Portfolio strategy, including interest rate sensitivity and credit selection, is determined by professional management, which operates under the classification norms prescribed by the SEBI. 

Tips to choose a bond fund

Here’s how to choose a bond fund!

• Match duration with investment horizon: The duration of the fund should correspond to the investor’s holding period. 
• Assess credit quality: The portfolio allocation must be analysed across rating categories, as higher-rated securities indicate lower default risk, whereas lower-rated instruments may carry risk.
• Evaluate interest rate outlook: The funds with longer duration respond more sharply to changes in policy rates and yield curve movements. 
• Review expense ratio & track record: The costs directly affect net returns. Historical performance should be examined across complete interest rate cycles rather than isolated periods.

Bond Fund Suitability

The suitability of a bond fund is determined by investment horizon, liquidity requirement, and risk tolerance.

• Income-oriented investors: Investors who want periodic income without direct participation in equity markets may consider bond funds aligned with their duration preference.
• Capital preservation with measured volatility: The short-duration and high-credit-quality funds may suit investors prioritising relative stability over return maximisation.
• Portfolio diversification: Investors holding significant equity investments may allocate to bond funds to moderate overall portfolio variability across market cycles.

Why do investors prefer bond funds?

Investors may prefer bond funds for the following reasons:

• Access to the debt market: Bond funds provide entry into government securities, corporate debentures, and money market instruments that may otherwise require significant capital or market connectivity.
• Liquidity with market valuation: The open-ended schemes allow entry and exit at existing NAV, while offering flexibility compared to holding individual bonds until maturity.
• Managed interest rate positioning: The portfolio duration and credit allocation are actively managed by professionals, which enables tactical adjustment in response to monetary policy actions, including those of the RBI.

Tax Implications on Bond Mutual Funds

The units of bond mutual funds acquired on or after 1 April 2023, any profit realised upon transfer or redemption is taxable as per the investor’s applicable ‘income tax rate’, without regard to the period of holding.

The dividend distributed from the scheme is taxed in the investor’s hands at applicable slab rates, and Tax Deducted at Source may apply if it exceeds ₹5,000 in a financial year. The redemption of units in debt mutual fund schemes does not attract Securities Transaction Tax (STT).

Risk of Bond Funds

Bond funds may carry the following risks: 

• Interest rate risk: When the policy rates rise, particularly following actions by the RBI, bond yields adjust upward and market prices decline. The funds with longer duration may exhibit greater sensitivity to such movements.
• Credit risk: The risk that the issuer may fail to meet scheduled interest or principal repayments is more pronounced in securities carrying lower credit ratings.
• Liquidity risk: In stressed market conditions, certain debt instruments may witness reduced trading activity, which may affect valuation and redemption efficiency.
• Reinvestment risk: The interest received by the fund may need to be reinvested at existing yields, which may be lower than earlier rates during a declining interest rate cycle.

Bond funds vs bonds

Bond funds and bonds both operate within the fixed income domain. Their mechanics, return patterns, and risk characteristics differ materially.

Aspects	Bond funds	Bonds
Structure	It is a collective investment vehicle holding a portfolio of debt securities.	It is a single debt instrument issued by a government or corporate entity.
Maturity	It has no fixed maturity for the investor, and the portfolio is continuously managed.	It carries a defined maturity date with stated principal repayment.
Return Pattern	The returns come from interest accrual and daily mark-to-market valuation changes.	The returns come from interest income and principal repayment at maturity, subject to the issuer’s credit risk.
Price movement	The NAV fluctuates with interest rate changes and portfolio duration.	The market price fluctuates until maturity but converges towards face value as redemption approaches.
Interest rate sensitivity	It is determined by the fund’s duration strategy and may change over time.	It is determined by the bond’s fixed maturity and interest payment structure.

Conclusion

A bond fund represents a gateway to the fixed income market, which combines diversification, professional management, and regulatory discipline within a single vehicle. Its performance is governed by duration, credit allocation, and current interest rate conditions. Therefore, proper evaluation requires alignment of investment horizon, risk tolerance, and tax treatment rather than reliance on historical return alone.

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