Had Net Fixed Assets Of Last Year-End And This Year-End Know Your Investment Risk in Bond Mutual Fund

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Know Your Investment Risk in Bond Mutual Fund

Fixed income unit trusts are touted as the safest asset class in unit trust investments. But is it as safe as fixed deposit?

The answer is NO.

A fixed deposit is a risk-free investment tool that guarantees you returns. A fixed income fund does not.

So what is the financial work behind a fixed income trust?

The fixed income fund invests in bonds. In this article, the terms fixed income fund and bond fund will be used interchangeably.

Connection

A bond is a fixed income security. If it is issued by the private sector, it is known as a corporate bond. They are considered debt instruments to raise capital to finance expenses or working capital without diluting ownership rights (unlike shares).

From the investor’s point of view, they will lend a sum of money to the bond issuer, and in return they will receive a predetermined rate of return (a coupon payment, usually in the range of 5 to 10 percent) on their capital annually/semi-annually/quarterly. In addition, the capital will be paid back to the investor when the bond defaults, usually within 1 year for short-term bonds (also known as Treasury bills) and 10 years for long-term bonds. The initial principal amount assumed may be less or greater than the final principal payment, the former known as a discount bond and the latter as a premium bond. In short, the investor is guaranteed to be compensated in a periodic coupon payment in addition to the value of the bond’s “price” discount.

Systematic risk

Systematic risk refers to the investment risk associated with local and global economic conditions. More often than not, this is the main risk for government bonds.

The net asset value (NAV) of a bond fund, which largely consists of a portfolio of government bonds, varies with the economy. This type of risk is something that no one can control, but it is perhaps more predictable. You will know that an economic recession is on the horizon by keeping up to date with many economic indicators such as the interest rate, the purchasing manager’s index and the business condition index.

Government bonds are almost akin to a risk-free investment, unless you live in a country like Greece, where the government may default on its nation’s debt. The United States, for example, has a triple As sterling bond rating until it is downgraded this year.

Unsystematic risk

The more unpredictable risk inherent in a bond fund is unsystematic risk. This type of risk is associated with an organization or corporation that issues the bond. It is more likely for a company, regardless of its size, if the company is poorly managed. The analogy is as follows. I collect amount of money from my family members and buy guarantee from you. You are the corporation issuing the bond to me, and I am the mutual fund itself, while my family members are the bondholders (investors). You take the money to gamble and end up losing it all. As a result, you cannot repay me either the principal or the periodic coupon payment. The fund disappears along with investors’ money when the bond issuer defaults on its financial obligations.

How to reduce the risk

Whichever bond fund you decide to invest in, take the time to read their financial statements twice a year. One is an annual report issued after the end of the fund’s fiscal year, and the other is an interim report. This may sound tedious if you are not a financier; but trust me, it’s something you can do in 30 minutes. You probably spend more time planning your vacation, why not spend some of that time flipping through annual reports when your money is at stake here?

Focus on the bonds held by the fund. See if the fund’s goals and mandates have changed. A mandate can mean the lowest category of bonds that a fund manager can own or buy for the fund. Each bond has its own rating that reflects the creditworthiness of the issuer of the bond. In layman’s terms, the higher the rating, the less likely the bond issue is to default. The rating is independently assessed by an agency such as Standard & Poor’s. Make sure all bonds held in the fund are investment grade (BBB and above). Any bonds held below this grade are considered junk bonds and should be a red flag. Cash in your money and look for other funds instead. It is not worth risking your money in junk bonds that may promise higher returns.

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