Understanding bond funds

AMID the volatile equity market and declining interest rate environment, investors look for investment instruments that can provide them with some stable income on their investments. Generally, bonds are deemed to be less volatile than equities and can provide stability to a diversified portfolio because of the steady stream of interest payments they provide.

Investing in bonds through bond funds

Bonds are traditionally confined to institutional players because they require a large investment amount. In Malaysia, the minimum trading block value for a single bond is normally RM5 million. On the other hand, bond funds offer an alternative investment avenue to retail investors as the minimum investment amount can be as low as RM1,000 since they "pool" money from many investors. Bond funds could provide diversification and reduce the risk of any single bond as they invest in a portfolio made up of individual bonds.

Investing in bond funds enables investors to access the experience and expertise of professional fund managers. Bond fund managers usually employ a structured investment process that combines intensive market research, vigilant risk management and disciplined portfolio construction in managing bonds. They have the skills and resources to identify opportunities and move between different types of bonds according to the market conditions. For example, the fund managers may want to maximise upside potential by increasing the portion of high yield corporate bonds in the portfolio.

Types of bonds

Before you invest in a bond fund, it will be useful for you to first understand the various types of bonds in the market. There are many types of bonds in the market depending on issuers (e.g. government bonds and corporate bonds), structure (e.g. convertible bonds, callable bonds and zero-coupon bonds) and interest rate fluctuations (e.g. inflation-linked bonds). Different types of bonds have different risk characteristics. For this article, we will discuss government and corporate bonds and their risk/return relationship.

Government bonds are considered to have the lowest risk with corresponding low return as governments have various sources of income such as taxes to repay the bonds when they reach maturity.

Conversely, corporate bonds can also be classified based on creditworthiness of the issuers. Investment grade corporate bonds with high credit ratings are usually issued by corporations with good financial standing and strong ability to meet all their financial obligations. These bonds carry lower risk compared to high yield corporate bonds, therefore they pay lower returns. In comparison, high yield corporate bonds, also known as junk bonds, are rated below investment grade at the time of purchase. This type of bonds provides higher returns as investors need to be compensated for taking additional credit risk.

Types of bond funds

There is a whole range of bond funds in the market. The difference between one bond fund and another is dependent on the investment objectives and strategies, which then determine the types of underlying bonds. For example, if you seek income and capital preservation, you may want to just consider government bond funds. However, if you are looking for more aggressive growth with some income, you can look at high yield corporate bond funds.

There were 77 bond funds in Malaysia with the total fund size of RM10.5 billion as at April 30 2009, representing 15 per cent of total fund size of the unit trust industry*. Bond funds can typically be categorised as conventional or Islamic funds. Of the 77 bond funds, 56 funds which made up 73 per cent or RM8.4 billion were conventional funds, and the remaining 27 per cent or RM2.1 billion were Islamic funds*. Islamic bond or sukuk funds provide investors a stream of "halal" income from issuers that are not involved in prohibited activities. These bond funds conform to Islamic principles that prohibit the charging or paying of interest.

Another type of bond fund that you can consider is an open-ended bond exchange traded fund (ETF). A bond ETF is a listed, passively-managed fund that tracks or replicates the performance of a bond index. For example, ABF Malaysia Bond Index Fund, **the first and only bond ETF in this country tracks the iBoxx(R) ABF Malaysia Bond Index. The fund allows investors to get immediate exposure to a diversified portfolio of mainly Malaysian government securities by just making a single purchase. Investors enjoy the flexibility to buy and sell during market hours just like trading shares. The cost of investing is generally lower than an actively managed unit trust fund as there is no entry fee and the management fee is also lower.

Risks of bond funds

Most bond funds aim to achieve potential income with the acceptable level of risks. Just like any other investments, bond funds carry some risks such as market risk and liquidity risk, in addition to the underlying bond risks including inflation risk, credit risk and prepayment risk that have been explained in the previous article.

Market risk is the risk of fluctuating net asset value (NAV) of a bond fund. The fund's NAV changes as the values of the underlying bonds change or the fund manager make changes to the fund's portfolio. Market uncertainties due to socio-political and regulatory factors, unfavourable conditions in overseas markets, changes in interest rates or currency exchange rates as well as broad investor sentiment can affect prices of the underlying bonds. For example, the NAV of a bond fund will drop if prices of the underlying bonds drop due to an increase in interest rates. In addition, the NAV of a foreign bond fund may increase if there are currency gains when foreign currencies move favourably against the ringgit.

By knowing the different types of risks associated with bond funds, you can better manage your expectations on potential returns. The professional management of a bond fund can help to minimise potential risks.

Conclusion

Bond funds have an important role in diversifying your portfolio and offer relatively predictable income. It is necessary for you to choose and determine the funds that provide the best balance of risks and potential returns based on your investment goals and risk appetite. You can leverage on the expertise of professional fund managers to maximum returns and minimise risks.

Successful bond portfolio management requires substantial resources and expertise to capitalise on market opportunities. To benefit from the stringent investment process, you can rely on bond investment solutions from award-winning fund management houses in creating a portfolio to meet your investment objectives.


* Source: Lipper Hindsight, AmInvestment Management as at 30 April 2009

** Source: Lipper Hindsight as at 31 March 2009

This article was contributed by the Funds Management Division of AmInvestment Bank Group.