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Tuesday, November 29, 2011
Bonds attractive asset during uncertain times
INVESTORS seeking regular income should consider investing in fixed-income
funds which can provide higher returns than fixed deposits and are ideal for
adding diversification to an investment portfolio.
In fact, during times
of economic uncertainties such as slower global economic growth, fixed income
assets generally tend to perform better than equity assets as bond prices will
be well-supported in a low inflationary environment. Moreover, the lower
volatility of fixed income returns provides investors with greater stability in
their investments over time.
Fixed income funds invest in a portfolio of
bonds, debentures and money market instruments. This article highlights one of
the most common fixed income fund offered by unit trust companies - bond
Definition of a bond
A bond is a type of security that functions
like a loan. Bonds are "I Owe Yous" (IOUs) issued by private companies,
municipalities, or government agencies. The money used to subscribe to a bond is
lent to the issuer - in other words, the company, municipality, or government
agency that issued the bond. In exchange for the use of this money, the issuer
promises to repay the amount loaned (also known as the face value of the bond)
on a specific maturity date. In addition, the issuer typically promises to make
periodic interest or coupon payments over the tenure of the bond.
bond is issued to the primary subscribers, it may be traded in the secondary
bond market. The price at which a bond trades, however, may fluctuate as bond
prices move inversely to changes in interest rates. When interest rates fall, a
bond's value usually rises thereby generating a capital gain for the bond.
Alternatively, when interest rates rise, a bond's value usually falls thereby
resulting in a capital loss on the bond.
funds invest in a portfolio of bonds with various maturities, issued by federal,
provincial, and municipal governments as well as major corporations. The aim of
a bond fund is to provide investors with income and/or capital gains from a
diversified portfolio of bonds. An investor can compute the return on his bond
fund by monitoring the movement in the fund's net asset value (NAV).
of the biggest advantages of bond funds is the diversification that can be
obtained with a small pool of investible funds. Instead of purchasing an
individual bond, which can be rather costly, investing in a bond fund allows an
investor exposure to several bonds from a variety of issuers with varying
interest rates and different maturities.
Unlike an individual bond, a
bond fund does not give a fixed rate of interest. The distribution paid by a
bond fund fluctuates depends on the income generated from its portfolio of
bonds. A bond fund generates income from the interest or coupon received and the
capital gain, if any, resulting from interest rate changes. One of the tasks of
the fund manager is to capitalise on the changing interest rate environment. To
optimise returns, a fund manager will position the bond portfolio by holding
bonds with longer maturities during period of declining interest rates and
switch to shorter maturity bonds when interest rates are rising.
fund also does not have a fixed maturity. However, a bond fund has an average
portfolio maturity, which refers to the average maturity dates of all the bonds'
in its portfolio. In general, the longer the fund's average portfolio maturity,
the more sensitive its NAV will be to changes in interest rates. Nevertheless,
bond funds that have longer average portfolio maturities tend to offer higher
yields to compensate investors for the higher interest rate risk.
Like all unit trust funds, investing in bond funds
involves investment risk, including the possible loss of principal.
Nevertheless, when you make an informed decision to assume some risks, you also
create the opportunity for reward. Investing in bond funds usually entails less
risk and more moderate returns as compared to investing in equity funds.
However, the expected returns for bond funds are higher than the expected
returns for money market funds or fixed deposits.
Investments in bond
funds are subject to interest rate risk and credit risk.
As explained earlier, bond prices fluctuate inversely to changes
in interest rates. In addition, prices of bonds with longer maturities are more
sensitive to changes in interest rates compared to shorter maturity bonds. For
example, a decline in interest rates will cause a larger price increase for a
10-year bond than for an equivalent 5-year bond. However, while longer-term
bonds tend to fluctuate in value more than shorter-term bonds, they also tend to
have higher yields to compensate for the higher risk.
Credit risk refers to the bond issuer's ability to pay interest
and to repay its debt. If a bond issuer is unable to repay principal or interest
on time, the bond is said to be in default. A decline in an issuer's credit
rating, or creditworthiness, can cause the NAV of a bond fund with exposure to
such bonds to decline. The credit risk of bonds are evaluated by independent
rating services, such as RAM Rating Services, Moody's Investors Service and
Standard & Poor's, which publish the bonds' credit rating periodically.