Debt Funds vs Bonds — The Difference Is the Maturity Date

You lend to one borrower, whether a government or a company, for a stated period. You receive interest on a schedule, and on the maturity date you receive the face value back.

If you hold it until that date and the borrower pays, the price movements along the way stop mattering. That is the source of the certainty people associate with bonds, and it is real, provided both conditions hold: you keep it to maturity, and the borrower does not fail.

Government securities remove most of the second concern. Corporate bonds do not, and the extra interest they pay is compensation for that, as our page on credit risk funds explains in the scheme context.

You own units of a portfolio holding many bonds with many maturity dates. As bonds mature, the scheme buys new ones, and money moves in and out as investors join and leave.

So there is never a date on which your units convert to a known amount. Their value reflects the market price of everything the scheme holds, every day, which is why a debt scheme can show a decline over months even if no borrower misses a payment. Our page on gilt funds explains why that happens even with government paper.

What you get in exchange is diversification, professional management, reinvestment handled for you, and the ability to redeem any amount on any business day.

Holding one corporate bond means your outcome depends entirely on that one borrower. If it defaults, a large part of your holding can be lost.

A scheme holding dozens of borrowers turns one default into a smaller dent spread across all unit holders. It does not eliminate the loss; it shares it.

For government securities this distinction barely matters. For lower-rated corporate paper it matters enormously, and it is the strongest argument for a scheme over direct holdings for anybody without the time or expertise to assess individual borrowers.

This is the practical difference people underestimate.

Scheme units can be redeemed on any business day at that day NAV, with the money arriving within a few working days, as our page on the cut-off time explains.

Selling a bond before maturity means finding a buyer. For widely traded government securities that is usually manageable. For many corporate bonds, trading can be thin, and a seller who needs money quickly may have to accept a lower price than the bond is worth. The certainty of holding to maturity disappears the moment you need to sell early.

So a bond suits money whose date matches the bond maturity. A scheme suits money whose date is uncertain.

A scheme charges an annual expense ratio, deducted inside the portfolio, which our page on the expense ratio covers. Holding bonds directly avoids that but may involve platform or transaction costs, and you manage the reinvestment of interest yourself.

There is also the question of what happens to the interest. A bond pays it out to you, and unless you reinvest it deliberately, it tends to be absorbed into ordinary spending. When the bond matures, you have to find somewhere new for the whole amount at whatever conditions exist then. A scheme handles both automatically, which is a small convenience that makes a real difference over many years.

Tax treatment differs between the two and has changed in the past for debt schemes specifically. How it affects you depends on your income and holding period, so it belongs with a tax adviser rather than with any general comparison. Our page on mutual fund taxation covers the structure on the scheme side.

A bond held directly suits somebody with a specific amount needed on a specific date, who can match a government or high-quality bond maturity to that date and will genuinely hold it until then.

A debt scheme suits money whose timing is uncertain, investors who want diversification across borrowers without assessing each one, and anybody who values being able to redeem part of the holding at any time.

Neither is a substitute for the buffer, which needs to be immediately available at a known value, as our page on building an emergency fund sets out. And neither belongs in a comparison with equity, since both sit on the stable side of the portfolio that our page on asset allocation describes.

• Do you know exactly when you need this money? If yes, a matched bond maturity is worth considering. If not, a scheme is the more flexible arrangement.
• How confident are you in assessing a borrower? If not very, spread the credit risk.
• Would you hold to maturity even if you needed the money earlier? Be honest.
• Have you checked the tax position for your circumstances?

For somebody deciding where a large sum should sit on the stable side, our page on investing a windfall covers the wider sequence. We deal in mutual funds rather than direct bonds, so we have no stake in which you choose for money that suits a bond better. Get in touch if you want to talk through a specific amount and date.