Akshay, 45, is a successful doctor. Like many of his colleagues, he is a risk-averse investor. He always invests his surplus funds in fixed-income products like bank fixed deposits (FDs) and bonds. However, being in the highest tax bracket, all his income from bank FDs gets taxed at the rate of 30 per cent plus. For this reason many of his friends have recommended that he should consider investing in bond funds.

What is a bond fund?

Bond funds are essentially mutual funds that invest in bonds. Most lay persons mistakenly think that since such funds invest in bonds, their capital would be protected at all times. Unfortunately, this is not true. The Net Asset Values (NAV) of bond funds fluctuate with changing interest rates.

Akshay was not comfortable with the idea of investing in bond funds because of a friend, Gauri’s, experience. She had invested in a bond fund hoping that her principal would be safe. But as interest rates rose the value of her investment declined. At one point, it fell below the original invested amount. Gauri spent a few sleepless nights. Then when the value of the fund returned to its original level she sold the fund.

When Akshay narrated this experience and asked for my opinions on bond funds, I told him that these things can happen, especially if you choose your bond fund incorrectly.

“So how does one go about choosing the right fund?” asked Akshay.

Credit rating

Of the factors that need to be considered when choosing a bond fund, three are most important. First is the credit rating of the bonds that the fund has purchased. It is best to choose a fund that holds AAA-rated bonds. This reduces the risk of losing the principal amount.

... contd.