Debt Funds – Fundamentals of Bond Funds?
Bond funds, also referred to as income funds, are basically mutual funds that offer steady income to investors. These can be among the safest forms of investment but are often among the most conservative too, meaning that the returns can be low. A comprehensive study of the features of bond prepares investors to choose the most appropriate bonds to suit their investment objectives.
How to evaluate bond funds
Bond funds can be evaluated on the basis of the kind of bonds they comprise of, the dates of maturity of bonds contained in the portfolio and various fees charged by the fund managers for running the fund. While some bond funds may invest in only one category, others may have a more diversified portfolio.
Investors may buy bonds from companies or governments. The investors loans their money to the bond issuer to get cash distributions based on an existing interest rate. At the expiry of the contract, issuer pays back the loan equal to the face value of the bond.
Some bonds, termed as high yield bonds, are comparatively risky, though these are designed to produce more profits, compared to traditional bonds. These have a higher risk of default. Bonds issued by state or local governments are different in the sense that the interest paid by such bonds is free from centralized income tax and probably state income tax. This aspect should not be overlooked while evaluating such bond funds.
Though bonds with longer maturity term generally deliver a better yield, compared to short term bonds, their prices are more vulnerable to bigger fluctuations due changing rates of interest. The value of bonds is inversely proportional to rates of interest, meaning the higher the rates of interest, the lower the value of bond fund. Naïve investors of bond funds tend to choose funds having long term maturity, giving higher yields and suffer losses with an increase in rate of interests.
Like any other mutual fund, bond funds also mention operating cost for running the fund. While investing in bond funds, investors should not overlook operation expenses as they directly influence their earnings. The more these expenses the less is the yield to investors.
Naturally, the most important factors for selecting a bond fund are its yield and safety. Funds offering maximum yield have non-investment-grade bonds having long maturity dates and these may be responsible for causing substantial loss of principal.
Investors looking for maximum safety would better invest in government sponsored bonds or bonds of companies with AAA rating and having a maximum tenure of five years.
Bond funds with a maturity period of five to ten years could offer better yield without increasing the risk substantially.
Investors of high yield junk bonds should certainly expect a higher yield to substantiate the risk associated with low rated securities. It is recommended to invest only a part of your resources in such bond funds.
Here is an illustration to explain the effect of expenses on the yield of funds. Let’s say two funds offer earnings of five percent, with one having an average expense ratio of 1.1 percent while the other has an expense ratio of just 0.4 percent. So, the yield from the first fund will be 5-1.1= 3.9%, whereas that from the other will be 4.6 5!