When direct bonds investment is better than investment in debt funds?

Question

Some good company (say SBI) bonds have coupon rate of 9%.

Q1. Does this imply that we can better invest in such bonds instead of debt funds (which have < 9% returns)? Or should I rephrase: why investing in such bonds is not good idea than investing in debt funds?

I have assumed below points while asking Q1:

• I have enough amount to buy large ticket bonds
• Such good company bonds are listed and hence can be liquidated easily. (Correct me if am wrong.)
• Listed bonds have the tax advantage of 20% capital gains tax along with indexation. So they have equal tax benefit as debt funds. (Correct me if am wrong.)
• High quality company bonds have near to zero credit risk. (Correct me if am wrong.)

Q2. I was guessing when debt funds are better than direct bonds investment. I feel that debt funds invest low quality bonds to increase returns and compensate risk, they diversify. This is the only reason that debt funds may be better (after above assumptions in bullet points). Am I right with this?

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Answer 1

why investing in such bonds is not good idea than investing in debt funds?

Individual bonds (especially those with a higher than average yield) are subject to default risk, meaning a chance that you won't even get the face value of the bond back. In general, the higher the yield of the bond, the higher the credit risk according to the market.

Bond funds obviously reduce this risk by diversification. While some bonds within a fund may default, the effect of a default is offset (on average) by higher coupons on other bonds (assuming you are looking at a high-yield bond fund).

High quality company bonds have near to zero credit risk.

A corporate bond with zero credit risk would not give you a yield higher than a government bond with the same maturity. Otherwise investors would borrow money and buy corporate bonds. The additional yield from corporate bonds comes from that small credit risk (or other features like callability, conversion, etc.)

I am not familiar with tax laws in India to know if there are any differences in taxation.

Answer 2

A coupon rate is not what you get when you purchase bonds in secondary markets. That was the yield on the face value of the bond, which was probably issued many years ago when interest rates were higher.

Talking about India specifically, most government-backed entities currently issue bonds with a coupon rate of 4-5%, which is actually lower than returns you would get from a corporate bond fund. This is because most corporate bond funds will also buy small amounts of bonds from companies that have lower credit ratings but offer higher yields.