Bond Funds: some basics

The recent upsurge in debt market has seen the performance of bond funds go up substantially. These funds hold major investments in bonds of different categories and so the downward change in yield has seen the returns from these funds soar high. However, despite the positive outcome, not many people know the mechanism and consequently are not aware of their pros and cons. We have just tried to explain what are bond funds and the factors that affect them.

What is a bond fund?
Debt funds by nature, bond funds like all mutual funds, are investment vehicles. They are meant especially for investors with relatively less appetite for risk and having an intention to earn returns higher than what are possible to earn from other avenues like Fixed Deposits that are considered as safe. So, safety and return both are of equal concern for those investing in Bond Funds. Most bond funds pay income regularly and their NAVs tend to fluctuate less than an equity fund.

Where do they invest?
In order to successfully achieve the goals of the fund, they invest in a multiplicity of debt instruments such as Corporate pares, papers issued by GOI etc. with different maturities and qualities. In order to balance the liquidity needs of investors who might want to redeem their funds any time, they also have exposure to money market instruments and call papers. Generally, mutual funds invest in bonds issued by different issuers such as government, corporate houses etc. Bonds can be classified on the basis of their issuer as:

1. Government Bonds

The Government Treasury and its agencies issue these bonds. Treasury bonds are considered the highest quality of all bonds because the credit of the government backs them and so the payment upon maturity is more or less guaranteed. In exchange for this very high margin of credit safety, they have the lowest yields.

2. Corporate Bonds

These are issued by various companies to finance their operations, expansion activities etc. Credit rating agencies such as CRISIL, CARE, ICRA rate these instruments in India on the basis of their degree of safety, which is defined as their ability to pay the amount on maturity. The risk-return trade off is witnessed here as well, for companies with good rating offer less yield.

3. Municipal bonds

These bonds are issued by governments and municipalities. Considered as reasonably safe, these bonds provide varying returns depending upon their maturities.

What affects the yield of a Bond Fund?
The returns from a bond fund are essentially the weighted average of the returns on each of its investment. So if a fund has invested in bonds of different maturities and yields, the yield from the fund will be the weighted average of the yields on different securities, weighted by the proportion of invested sum. The quality of papers and average duration of the portfolio are some of the factors that determine the returns one can earn from the fund. However, the prices and yields of bonds can fluctuate like other investments and so there is some risk inherent even in bond funds and they are not absolutely risk-free as they are often made out to be.

What are the risks associated?
Bond funds invest in bonds and like any investment are affected by some risks. There are several risks associated with bonds and so they also affect the funds that invest in bonds. They are:

Interest-rate risk
Unlike stock market where an upward movement of market leads to upward movement in stock prices, it is a fall in the market yield that pushes up the prices of debt securities. This happens because there exists an inverse relationship between the yield and the price of a bond. So, if there is an upward movement of interest rates after one has invested in a bond fund, the prices of bonds will go down leading to a corresponding fall in the NAVs of the bond funds. Let us take an example:

Suppose a person buys a bond for Rs. 100 with a coupon rate of 10 percent. In other terms the person should get Rs. 110 at the end of the year. If the RBI announces a hike in the bank rate and the market yield for the duration of the bond increased, say to 11 percent, the prices of the bond will fall around to Rs. 90.91 in order to adjust to the market yield. This is termed as interest rate risk in financial jargon and is precisely what happened in 2000 when RBI had hiked the interest rates.

An investor stands to benefit in the opposite scenario, when the interest rates are cut as then the prices go up leading to better returns from the fund. If the interest rate in the above example falls to 9 percent, a person still gets Rs. 10 in interest but in order to align the amount received to the prevailing market yield, the price of the bond adjusts to Rs. 111.11. In this case, the investor is better of by selling it at Rs. 111.11 than holding it to its maturity, as then he will only get Rs. 110.

This risk is also dependent upon the maturity and duration of the bond and generally, the longer a fund's duration or average maturity, the higher its interest-rate risk, or the more sensitive the NAV of the fund will be to changes in interest rates. One can reduce the interest rate risk by choosing a bond fund with a shorter duration or average maturity.

Credit risk
Just like shares where the performance of the company has some bearing on the stock prices, credibility of the issuer is of importance in debt instruments. The risk of the issuer not being able to make payments on his liabilities (debt instrument) is termed as default risk or credit risk. This is of special concern to the investor if the fund is investing into junk bonds or lower quality bonds. Bond funds offer professional management and a range of quality ratings to help lower this risk and so investors stand to benefit by the expertise of fund to pick good papers only.

Delay Risk
Cash flows are estimated on the basis of the pattern of income distribution. For example, a bond can pay interest half yearly, on fixed dates and so if there is any delay in receiving payments from the issuer, there is bound to be a mismatch between the cash flows. This can be termed as the delay risk. Mutual funds too can miss out on the interest due on an investment and have to show it as accrued but not received. This also affects the time value of the money due. A continuation of this trend may lead to a re-rating of the paper and add to the non-performing assets of the fund.

Balancing Risk vs. Reward
As with any investment in any category, there is always a trade-off between the risks taken and returns generated. The greater the risk of a bond fund (dependent on the quality and duration of papers), the higher is the potential reward, or return. With a bond fund, the risk that prices may fluctuate and the value of your investment may increase or decrease is not eliminated and so one must choose funds based on his risk tolerance.