Many newbie investors often wonder what the difference between mutual funds and bonds is. Both are investment instruments that can land you profitable returns, depending on your investment goals and risk tolerance.
Having a clear understanding of what they are will be vital in helping you decide which one suits your investment profile better. Therefore, this article discusses the difference between mutual funds and bonds and gives you insights on where to start with them.
What are Mutual Funds?
Mutual funds are investment vehicles that pool funds from different investors to invest in a diversified portfolio. This portfolio could include stocks, bonds, money market instruments, commodities, or other securities, depending on the mutual fund’s investment objectives. They’re actively managed by professional fund managers or investment firms who make investment decisions on behalf of the investors.
The net asset value (NAV) of a mutual fund is determined by the values of the securities in the fund. Therefore, when you invest in the fund, you get units of the fund based on your contribution to its NAV. You can choose to redeem your units of the fund at any time or reinvest it into the funds if you’re looking at the long-term.
Types of Mutual Funds
Here are the main types of mutual funds:
Equity Funds: Equity funds are mutual funds that invest primarily in the stocks of companies. They can be categorized into large-cap funds, mid-cap funds, small-cap funds, and sector funds. Equity funds are suitable for investors looking for higher returns but are not ready to take on the risks of investing in individual stocks.
Debt Funds: Debt funds, or bond funds, are mutual funds that invest primarily in debt instruments, such as bonds, debentures, commercial papers, etc. They’re much safer than equity funds and work well for investors looking to generate periodic income.
Hybrid Funds: Hybrid funds are mutual funds that contain more than one asset class in their portfolio. They usually contain debt and equity funds and sometimes include other instruments. The major aim of hybrid funds is to diversify the risk of the portfolio and create a balance between capital appreciation and regular income.
Money Market Funds: These mutual funds invest in short-term, low-risk securities such as treasury bills, certificates of deposits (CDs), and commercial papers. They’re safer than other types of mutual funds, as they aim for capital preservation and liquidity instead of significant capital appreciation.
What are Bonds?
Bonds are debt securities issued by governments, corporations, or municipalities to raise capital. They’re more like loans given to these institutions to enable them to carry out projects.
When you buy a bond, you’re lending money to the bond issuer in exchange for periodic interest payments (also known as coupon payments) and the return of the principal amount at maturity.
Types of Bonds
Here are the main types of bonds:
Government Bonds: These bonds are issued by the government to raise capital for public projects. They have the least chance of default, as it’s guaranteed the government will pay back.
Corporate Bonds: These bonds are issued by corporations to raise money for various purposes, including expansion, acquisition, or debt financing. Corporate bonds are usually riskier than government bonds and also pay a higher interest rate.
Convertible Bonds: These bonds are issued by companies and come with the option to convert into a predetermined number of shares of the issuer’s common stock.
Fixed Rate Bonds: These bonds have fixed interest rates throughout their term. They’re suitable for investors who want predictable returns amidst economic fluctuations.
Key Differences between Mutual Funds and Bonds
Mutual funds and bonds are investment options with different characteristics. Here are the key differences between them:
| Parameters | Mutual Funds | Bonds |
| Nature of investment | When you invest in mutual funds, you’re pooling funds with other investors to buy a portfolio of assets. | When you invest in bonds, you’re lending money to the government or corporation in exchange for periodic interests. |
| Liquidity | They are highly liquid, as they can be traded during market hours. | Varied liquidity, depending on the maturity date. Some bonds can be traded on exchanges. |
| Interest rate | Some mutual funds, like bond funds, money market funds, and balanced funds, pay interest. Others focus on capital appreciation and dividend payments. | Bonds pay interest on a fixed or floating rate, depending on the bond type. |
| Diversification | Provides diversification across different asset types, sectors, or geographic locations. | Offers major diversification across sectors. |
| Composition | They can comprise various financial instruments, such as equity, debt, commodities, etc. | Fixed income assets |
| Management | Managed by the fund managers of the company | Managed by the issuing institutions |
| Risk and return | Risk and return depend on the performance of the underlying assets. Equity funds are riskier than bond or money market funds. | Bond risks depend on the creditworthiness of the issuer and inflation. Returns depend on the interest rate and maturity value. |
Now that you understand the differences between mutual funds and bonds, let’s look at where you can start investing in them.
Where to Start with Your Investment in Mutual Funds and Bonds
To start your investment in either mutual funds or bonds, here’s a process to follow:
Determine Your Financial Goals and Risk Tolerance
The first thing you must do when considering investing in mutual funds and bonds is to determine your financial goals and risk tolerance.
If you want regular income and capital preservation, bonds might be a suitable starting point. But if you’re willing to take more risks and potentially earn higher returns, mutual funds might be a great fit.
Study Mutual Funds and Bonds
Educate yourself about mutual funds and bonds and what they can add to your investment portfolio. Study their characteristics, risks, and potential returns to make sure you want to commit your funds to any of them.
Assess Investment Options
Once you have a clear understanding of what mutual funds and bonds are, evaluate available mutual funds and bonds. Examine their investment objectives, past performances, fees, and management quality.
If need be, consult a financial advisor to help you in choosing the investments that align best with your goals and risk tolerance.
Embrace Diversification
Whether you start with mutual funds or bonds, it’s essential you embrace diversification from the onset. Consider diversifying across asset classes, such as stocks, bonds, etc., and within each asset class. This helps you spread your risk exposure and increases your chances of earning guaranteed returns.
Also Read: 7 Investment Mistakes You Must Avoid in Dubai
Conclusion
The major difference between mutual funds and bonds is that mutual funds are a portfolio of diversified assets, which can include bonds, while bonds are debt instruments.
Understanding their characteristics, risks, and return potential will help you make an informed choice on which one you should add to your portfolio.
