An article written by Ray Calleja: Head – Private Clients, MeDirect
So far in our articles, we have mainly focussed on Equity Funds. As we have already discussed, it is important to decide on your asset allocation, especially when you are investing with a long-term outlook. Mutual funds are broadly divided between bonds funds and equity funds.
Equities usually grab the main headlines, while bonds, which deliver regular income, are sometimes hardly noticed. However, they do play a defensive role in any investment portfolio and help preserve capital. Bond funds have long been favoured by investors seeking a steady cash flow at low risk.
For a quick recap when you buy a bond you are giving a loan to the Issuer of the bond, whether that is the government or a company. The bond will be for a certain period of time and your loan amount will be repaid on the maturity date of the bond. You will be paid interest on a regular basis, usually once a year but can be more frequent. The interest paid is commonly known as the coupon of the bond. So, with bond investing you would be interested in the duration of the bond, the interest that is paid and the ability of the issuer to repay the bond on the maturity date.
Interest Rate Risk
Bond market prices move in the opposite direction of interest rates. When rates fall, bond prices move in the opposite direction and rise. Inversely, when interest rates rise, bond prices fall.
Interest rate risk (also called market risk) is the risk that changes in interest rates may reduce or increase the market value of a bond you hold. Interest rate risk increases the longer you hold a bond.
The factors that get involved here are the maturity of the bond, the cash flows from the interest payments and the prevailing interest rates in the market. Let us consider a scenario where you have rising interest rates. Say you have a 10-year €1,000 bond at a coupon rate of 3% and interest rates rise to 5%. If you want to sell your 3% bond before maturity you must compete with bonds issued more recently carrying higher coupon rates. These bonds with a higher coupon rate will decrease the appetite for older bonds that pay lower interest. This decreased demand lowers the price of older bonds in the secondary market, which would translate into receiving a lower price for your bond if you want to sell it. You may even have to sell your bond for less than you paid for it, if you need the money.
Rising interest rates also make new bonds more attractive because they earn a higher coupon rate. This results in what is know as opportunity risk – the risk that a better opportunity will come around that you may be unable to take. Thus, the longer the term of your bond, the greater the chance that a more attractive investment opportunity will become available, or even any other factor which may occur, which would negatively impact your investment. This is also referred to as the holding-period risk – the risk that something may happen during the time you hold a bond to negatively affect your investment. Bond fund managers face the same risks as individual bond-holders. Consequently, when interest rates rise the value of the fund’s existing bonds drops, which will then put a drag on the fund’s overall performance.
The next risk to consider after the interest rate risk is Credit Risk, which is related to the fund’s credit quality, which measures the ability of an issuer to repay its debts.
A company’s ability to pay its debts is captured in a credit rating. Credit-rating agencies, such as Moody’s; Standard & Poor’s; Fitch Ratings etc. closely examine a company’s financial statements to establish the financial health of the company. They assign a letter grade to the company’s debt with AAA indicating the highest credit quality and D being the lowest.
Each agency uses its own ratings definitions and employs its own criteria for rating a given security. It is entirely possible for the same bond to receive a rating that differs, sometimes substantially, from one agency to the other. While it is a good idea to compare a bond’s rating across the various agencies, not all bonds are rated by every agency, and some bonds are not rated at all. In such cases, you may find it difficult to assess the overall creditworthiness of the issuer of the bond.
Bonds rated AAA, AA, A and BBB are called investment-grade bonds, which will give the bondholders confidence that all interest payments should be made and that the bonds should be repaid in full on maturity. Bonds rated BB, B, CCC, CC, and C are non-investment-grade, or high-yield, bonds. That means there is a reasonable chance that the bond issuer will default on its obligations. In fact, D, the lowest grade, is reserved for bonds that are already in default.
As an investor you are unlikely to select a lower-rated bond unless you get some sort of incentive. That incentive comes in the form of higher yields. All other things being equal, the lower a bond’s credit quality, the higher its yield. That is why you can find a high-yield bond (also known as junk bonds) fund with a yield which is considerably higher than the yield paid by investment-grade bond funds. Because investment-grade issuers are more likely to meet their obligations, investors are still likely to opt for the better-quality bonds that pay a comparatively lower coupon.
Credit quality can also affect the value of a bond. Specifically, lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession. Recessions usually mean lower corporate profits and thus less money to pay to bondholders. If an issuer’s ability to repay its debt looks unsure in a healthy economy, it will be even more uncertain in a recession. High-yield bond funds usually drop in value when investors are worried about the economy.
Government bonds in the developed world, such as U.S. Treasury bonds, are generally deemed to be free of default risk. Other bonds face a possibility of default. This means that the bond issuer will either be late paying bondholders, pay a negotiated reduced amount or, in worst-case scenarios, be unable to pay at all.
The Morningstar Fixed Income Style Box
MeDirect’s partners, Morningstar have created their fixed-income style box, which is a nine-square box, which gives a visual snapshot of a fund’s credit quality and duration. The style box allows investors to quickly gauge the risk exposure of their bond fund. Incidentally, fixed income is a term used to include investments like government and corporate bonds, certificates of deposits and money market funds.
The horizontal axis displays a fund’s interest-rate sensitivity, as measured by the average duration of all the bonds in its portfolio. Morningstar breaks interest-rate sensitivity into three groups: limited, moderate, and extensive. As explained above, short-term (or limited) bond funds are the least affected by interest-rate movements and thus the least volatile; long-term (extensive) funds are the most volatile. Morningstar divides funds into these buckets based on their duration relative to the 3-year effective duration of a core bond index.
The vertical axis of the style box measures credit quality and is also broken into three groups: high, medium, and low. A fund’s placement is determined by the average credit quality of all the bonds in its portfolio, and also adjusts for the fact that default rates increase more rapidly between lower grades than higher grades. Funds with high credit qualities tend to own Treasury bonds or corporate bonds whose credit quality is of the highest quality. On the other hand, funds with low credit quality own a lot of high-yield, or junk bonds. Medium-quality funds fall between these two extremes.
The style box can make it far easier for investors to find appropriate funds. If you are looking for a fund that carries only slightly more risk than a money market fund, you will need to look for funds that fall within the short-term, high-quality square of the style box. Or you may want a high-income stream but you are not comfortable buying junk bonds. A fund that falls within the long-term, medium-quality square might be the answer. You can find the style box for all bond funds on MeDirect’s website in their Morningstar Fund Reports.
Things to Consider
Bonds typically gain less than stocks over time, so you are unlikely to see much capital growth in bond funds. You should therefore be more wary of costs.
Typically, high-cost bond funds often take on more risk than low-cost bond funds. Expenses get deducted from the income the fund pays to its shareholders, so managers of high-cost funds often do take on more risks to keep yields competitive, such as buying longer-duration or lower-quality bonds, or complex derivatives. In doing so, they increase the fund’s risk. Managers with low expense hurdles, in contrast, can offer the same yields and returns without taking on extra risk.
Many bond fund investors tend to focus on yield, especially those focussing on income for retirement. However, there have been cases where some funds prop up their yields whilst sacrificing the principal value or NAV. Some fund managers may be paying more than face value for high-yielding bonds and distribute that entire yield as the bonds depreciate to face value, or they actually dip into your principal in order to pay out a high yield. That payout will be reflected in a NAV, or share price, that shrinks over the years.
Therefore, it is important that you judge a bond fund by its total return rather than just its yield. By total return we mean its yield plus capital appreciation (or minus any depreciation) plus compounding of those gains over time. Yield would still be the lion’s share of a bond fund’s return, but you want to make sure that the fund is not depreciating its NAV to provide that yield.
For your first and possibly only bond fund, do seek variety and consider intermediate-term, broad-based, high-quality bond funds that hold both government and corporate bonds. Morningstar, tend to favour funds with short- and intermediate-term durations, i.e. between 3 and 6 years. They are less volatile than longer-term durations funds and offer more or less the same return.
Because bond prices move in the opposite direction of interest rates, in past years, the extended period of falling rates meant that bond investors experienced a very profitable time and have done exceptionally well. But now that interest rates have already fallen so significantly, bringing down yields to levels that are not at all appealing, more capital gains are now very unlikely. When interest rates do move up, higher bond fund values will be at risk.
So just how much bond fund exposure should you have? Just like with any other asset class, it depends on your time horizon, your risk tolerance and investment objectives. As you near retirement you are more likely to seek out regular income from a stable investment and bond funds can provide such stability. On the other hand, you should not rely too much on bond funds as you grow older especially with people living into their 80s and even 90s, your nest egg will need to last you long enough for the rest of your life. It is therefore very important that you continue to hold investments slanted towards growth in your later years, to be able to protect your income and capital from inflation over time.
Once you have established what amount you will place in fixed income, regular rebalancing will help you make sure that your investment portfolio remains properly allocated and diversified.
In her article, ‘7 Steps to Tidy up Your Investment Portfolio’, dated 13 July 2020, Christine Benz, Director of Personal Finance at Morningstar says, “Thus far in 2020, the safest bond funds have held up best, whereas riskier bond-fund types are still clawing their way back from big losses in the first quarter. Of course, yields on high-quality bonds are incredibly low today, but their relative and absolute year-to-date strength demonstrates, yet again, that the most boring, highest-quality bonds will tend to hold up best in market shocks. If you’re adjusting your fixed-income portfolio, redeploying money from higher-risk bond segments into lower-risk alternatives will improve your total portfolio’s diversification and risk level, even as it’s likely to lower the yield.”
As stated by Ms Benz, although it is unlikely that bond funds will continue to generate above-average returns, it does not mean that they are no longer valuable to your portfolio. Bond funds can still play an important role to provide regular income while helping to keep your portfolio steady, especially at uncertain times like we are living now. But as mentioned earlier with the possibility of capital gains being less likely and the low interest rate scenario remaining as it is, for the foreseeable future, it is important that you are realistic of what to expect from your bond funds.
The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.
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