Bonds and bond funds are an important part of a balanced investment portfolio. For most investors, the cost of building a diversified bond portfolio is prohibitive. Bond mutual funds are cheaper and more efficient.
In general, stocks and stock mutual funds provide higher returns than bond funds over the long term–but that higher return comes with higher risk. Bond funds tend to be less volatile than stock funds, and they can also provide you with a source of steady income.
Within the world of bond funds, there are also different levels of risk and return. Just as you would want your first stock mutual fund to own a broad, diversified group of stocks, it is a good idea for your first bond fund to own a mix of government and corporate bonds, which have different levels of risk, perform differently in different environments, and offer different levels of yield. Of course, that still leaves you with a lot of funds from which to choose.
Here are some specific factors to consider when choosing a bond fund:
TERMS TO KNOW
Average Maturity: A debt fund portfolio comprises several bonds with varying maturity dates. Average maturity is the weighted average of maturity for all bonds in the fund portfolio.Modified Duration: The duration is the measure of price sensitivity of the portfolio to change in interest rates. For instance, if interest rates go down (or up) by 1% in a month, the NAV of the fund will go up (or down) by 4% if modified duration is four years.
Yield to Maturity: The Yield to Maturity (YTM) is what the bond will earn from its coupon payments as well as annualised gain (or loss) on purchase price, if held till its maturity.
CHOOSING RIGHT
Average Maturity: A debt fund portfolio comprises several bonds with varying maturity dates. Average maturity is the weighted average of maturity for all bonds in the fund portfolio.Modified Duration: The duration is the measure of price sensitivity of the portfolio to change in interest rates. For instance, if interest rates go down (or up) by 1% in a month, the NAV of the fund will go up (or down) by 4% if modified duration is four years.
Yield to Maturity: The Yield to Maturity (YTM) is what the bond will earn from its coupon payments as well as annualised gain (or loss) on purchase price, if held till its maturity.
CHOOSING RIGHT
Match time horizon with maturity profile: Ascertain the time period for which you wish to stay invested and identify a fund with a matching maturity profile
Match risk tolerance with credit profile: Debt funds invest in several instruments, from risk-free government securities to high-risk corporate bonds. Instruments are assigned a credit rating indicating the credit worthiness of borrower. Higher the credit rating, safer the investments.
Ascertain interest rate scenario: When interest rates rise, it makes sense to move to short term debt funds, while falling rates work in favour of longer duration debt funds.
RISKS INVOLVED
Interest Rate Risk: Debt funds are exposed to risk of interest rate fluctuations, which affect prices of underlying bonds in the fund portfolio.
Credit Risk: Debt funds are also exposed to the risk of default by the issuer of underlying instrument. Checking the credit profile of the fund is important. Returns can be enhanced by lowering credit quality of the portfolio, which enhances the credit risk.
Liquidity Risk: Liquidity is the ease with which a fund manager can sell a particular security in the market. A fund faces liquidity risk if the fund manager is not able to do so due to lack of demand for the security.
WHICH FUND IS FOR YOU?
GILT FUNDS
Invests In: All types of government securities of varying maturities.
Risk Factor: High. Zero default risk but high interest rate risk.
Holding Period: 18-24 months
Who Should Invest: Since underlying bond prices will fluctuate wildly, only those who are comfortable with a high degree of risk and looking for capital appreciation instead of protection should invest.
SHORT-TERM FUNDS
Invests In: Commercial papers, certificate of deposits and bonds with a maturity of 3-6 months.
Risk Factor: Low. Not affected much by changes in interest rates. HOLDING PERIOD 6-12 months
Who Should Invest: Investors looking to park surplus money, but want to earn higher return than a liquid fund.
INCOME AND DYNAMIC BOND FUNDS
Invests In: Mix of bonds, corporate debentures and government securities.
Risk Factor: Medium-High. These can shift between maturities aggressively in anticipation of rate changes.
Holding Period: 3-5 years
Who Should Invest: High risk takers who want to gain from both rising and falling interest rate scenarios.
CREDIT FUNDS
Invests In: High yield but lower credit quality instruments.
Risk Factor: Medium-High. Low interest rate risk, but default by issuer of underlying bond and downgrade in credit rating of underlying instrument can hurt NAV.
Holding Period: 3-5 years
Who Should Invest: Investors who do not wish to play the guessing game on interest rates and are willing to take higher risk for higher yield.
LIQUID FUNDS
Invests In: Highly liquid instruments like treasury bills, inter-bank call money market, etc.
Risk Factor: Very low
Holding Period: Up to 3 months
Who Should Invest: Investors who have surplus money lying idle and seeking better returns than interest offered by banks.
FIXED MATURITY PLANS
Invests In: Instruments with maturity profile matching fund tenure.
Risk Factor: Low-Medium
Holding Period: 3 years or more
Who Should Invest: Those looking to park their money for a fixed tenure during uncertain interest rate movements.
Match risk tolerance with credit profile: Debt funds invest in several instruments, from risk-free government securities to high-risk corporate bonds. Instruments are assigned a credit rating indicating the credit worthiness of borrower. Higher the credit rating, safer the investments.
Ascertain interest rate scenario: When interest rates rise, it makes sense to move to short term debt funds, while falling rates work in favour of longer duration debt funds.
RISKS INVOLVED
Interest Rate Risk: Debt funds are exposed to risk of interest rate fluctuations, which affect prices of underlying bonds in the fund portfolio.
Credit Risk: Debt funds are also exposed to the risk of default by the issuer of underlying instrument. Checking the credit profile of the fund is important. Returns can be enhanced by lowering credit quality of the portfolio, which enhances the credit risk.
Liquidity Risk: Liquidity is the ease with which a fund manager can sell a particular security in the market. A fund faces liquidity risk if the fund manager is not able to do so due to lack of demand for the security.
WHICH FUND IS FOR YOU?
GILT FUNDS
Invests In: All types of government securities of varying maturities.
Risk Factor: High. Zero default risk but high interest rate risk.
Holding Period: 18-24 months
Who Should Invest: Since underlying bond prices will fluctuate wildly, only those who are comfortable with a high degree of risk and looking for capital appreciation instead of protection should invest.
SHORT-TERM FUNDS
Invests In: Commercial papers, certificate of deposits and bonds with a maturity of 3-6 months.
Risk Factor: Low. Not affected much by changes in interest rates. HOLDING PERIOD 6-12 months
Who Should Invest: Investors looking to park surplus money, but want to earn higher return than a liquid fund.
INCOME AND DYNAMIC BOND FUNDS
Invests In: Mix of bonds, corporate debentures and government securities.
Risk Factor: Medium-High. These can shift between maturities aggressively in anticipation of rate changes.
Holding Period: 3-5 years
Who Should Invest: High risk takers who want to gain from both rising and falling interest rate scenarios.
CREDIT FUNDS
Invests In: High yield but lower credit quality instruments.
Risk Factor: Medium-High. Low interest rate risk, but default by issuer of underlying bond and downgrade in credit rating of underlying instrument can hurt NAV.
Holding Period: 3-5 years
Who Should Invest: Investors who do not wish to play the guessing game on interest rates and are willing to take higher risk for higher yield.
LIQUID FUNDS
Invests In: Highly liquid instruments like treasury bills, inter-bank call money market, etc.
Risk Factor: Very low
Holding Period: Up to 3 months
Who Should Invest: Investors who have surplus money lying idle and seeking better returns than interest offered by banks.
FIXED MATURITY PLANS
Invests In: Instruments with maturity profile matching fund tenure.
Risk Factor: Low-Medium
Holding Period: 3 years or more
Who Should Invest: Those looking to park their money for a fixed tenure during uncertain interest rate movements.
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