A bond fund is generally suited to more cautious investors
Bond funds hold a selection of individual government and corporate bonds and other debt instruments. All of these instruments are guaranteed by the borrower – in other words, the institution that issues each instrument. Any risk is directly related to the institution’s ability to repay the amount borrowed when the loan matures at the end of a stipulated period. Provided there is little or no risk of default, investors can feel fairly secure they will receive a regular income and that the capital will remain intact.
Bond funds introduce a strong element of stability to investment portfolios
The individual bonds in which the fund invests pay income at fixed rates of interest and at fixed intervals. This means that investors enjoy a steady and stable source of income.
Investors should choose bond funds that match their personal risk/return profiles
Government bonds are the safest investment of all since a government can always “print more money” to pay its debt and they offer an explicit government-backed guarantee. The yield on risk-free investments of this kind is correspondingly lower than yields offered by other parastatal or corporate bonds.
In a low return environment, investors are hungry for the higher yields that are offered by the corporate rather than the government sector because they are not regarded as “risk-free” investments ie backed by government.
Thus corporate bond yields tend to trade at a premium to government bonds. The extent of the premium is dependent on the credit rating given to the specific bond issue and ratings range from AAA-rated investment grade through to junk bonds, with ratings of less than BBB.
Some private sector bond funds specialise in investing in even higher yielding securities (so-called junk bonds) that have credit ratings that are below investment grade. These bonds carry a higher degree of risk due to the risk that the issuing company may not be able to repay the bond for some reason.
Conventional bond funds that are found in the SA – Interest Bearing – Variable Term category of the unit trust world, like the SIMBond Plus Fund, do not have material exposure to these bonds but instead are mostly invested in government, parastatal and blue-chip corporate bonds.
So if your primary objective is to maximise yield, you may want to consider a fund in the SA – multi-asset – income category, like our popular SIM Active Income Fund, which as more flexibility over where it can invest. This does mean, however, the investor is exposed to more risk.
Bond funds have many advantages for investors
- Professional investment management. They have dedicated managers with high levels of expertise and a lot of experience in determining where value lies within the fixed interest environment.
- Diversification. They invest in many individual bonds so that even a relatively small investment is well diversified. When an underperforming bond is just one of many bonds in a fund, its negative impact on the overall portfolio is reduced.
- Regular monthly income. Income can either be distributed monthly or automatically reinvested.
- Unit trust benefits. As unit trusts, bond funds offer investors the usual liquidity, security and breadth of choice.
Investors in bond funds should also bear in mind
- The net asset value of a bond fund may change over time but when it does it is usually not in the same direction as an equity fund because the two asset classes tend to be uncorrelated and thus respond differently to different market conditions.
- They do not offer the same potential for capital appreciation as funds that invest in equities or listed property.
By Sanlam Investment Management; September 17.