Bonds play an important role in your personal finance plan. The quantum of income which the bond funds add to your portfolio depends on the role you assign to them. Broadly speaking, there are two ways to make money from bond funds: one is to earn a regular income and second is to seek capital appreciation.
Fixed income or capital appreciation?
As an asset class, bond investments include all fixed income bearing instruments such as fixed deposits and government bonds. The government securities give a stable income if you want to earn a regular interest. Likewise, if you consider fixed deposits in your portfolio, it is the capital appreciation that is taken into account.
Several investors decide to invest in bond funds because the returns are more than the interest income accrued on bonds. However, the pitfall of this strategy is that the bonds are prone to market risk. This means the bond prices have an inverse relationship with the interest rates.
When interest rates increase in the market, the bond prices fall and when the interest rates decline, the bond prices tend to surge. Now, the fact of the matter is that the interest rates do not generally fall significantly in a short span of time to make a sizable impact on the bond prices.
On the flip side, the rates also do not rise too high all of a sudden to make the bond prices decline sharply.
Whenever you place your bets on bond funds, do keep in mind these nuances.
Another key factor to consider is the modified duration. The risk that a bond fund is exposed to is measured by modified duration. This means when the modified duration of a bond is 6, then the value of the portfolio would fall by 6 percent when bond yield rises by 100 basis points.
So, we can summarise that one should invest in equity for capital appreciation, and in bonds for fixed income. The investment in bonds can offer stable income but not so high returns.