Check list for investing in bond funds

Mutual fund houses launch bond funds for conservative investors who expect steady returns on their investments. That apart, bond funds are also more tax-efficient than fixed deposits for investors in the higher tax bracket. However, there are certain risks associated with bond funds. Let us examine the kind of risks that bond funds are exposed to.

Credit risk: This is the biggest risk that an investor needs to consider before investing in any bond fund. The risk of default by the issuer in the repayment of the principal amount cannot be ruled out if the financial situation of the issuer deteriorates. Such default might lead to partial or total loss of capital. Hence, you need to make sure that the portfolio of the scheme comprises of highly rated (AAA) securities.

Interest rate risk: The upward or downward movement of interest rates impact the yields of bond funds, which have an impact on their returns. This is because when interest rates go up, the bond prices fall; and vice versa. This is particularly true in the case of bonds with long duration maturities, which are impacted the most by interest rate movements. In the case of bonds with short-term maturities, the risk is minimal. Hence, those with a lesser appetite for interest risk should go for funds investing in short-dated securities.

Administration risk: If the expense ratio of the scheme is high, it will adversely impact the returns of the scheme. Also, if the fund house charges exit load at the time of repurchase, then it will reduce your returns to that extent.

Fund management risk: The risk of a highly experienced and expert fund manager leaving the fund house can also adversely impact the returns of a bond fund as the fund manager takes crucial calls relating to interest rate risks and credit risks. Also, if there is a huge decrease in the assets under management due to large redemptions, the expense ratio will go up, thereby reducing the returns on investment.