Bond behaviour

Bonds can create steady income and stability in a portfolio -but don’t count on bond mutual funds to deliver the same guarantee.

Bonds serve as a staple in the portfolios of many investors who look to them for the steady flow of income and stability they can create in a portfolio. But if predictability and safety of capital are your primary investment objectives, don’t count on bond mutual funds to deliver the same guarantee. Unlike equity funds, which tend to mirror the characteristics of the stocks that they hold, bond funds can behave very differently from their components.

The differences between buying a bond and investing in a bond mutual fund are based on the two approaches that can be taken to bond investing. The lower-risk approach — that is, using a bond for fixed-income purposes — entails buying and holding the bond for the long-term, in most cases until maturity. The second, riskier bond strategy is to use bonds as a play on interest rates. With this strategy, one attempts to anticipate the direction and degree to which interest rates will fluctuate, and manages bond holdings to profit from these moves.

To understand why these differenc are important, it’s necessary to understand what bonds represent and the factors that affect their pricing.

Bonds are debt instruments issued by companies and governments who borrow money from investors to fund their business activities. When you buy a bond, you are lending money to the issuer in return for a promise that this loan will be repaid at a specified date and, in the meantime, you will earn a set rate of interest for your trouble.

Since bonds trade on the open market, their prices fluctuate according to market outlook. The main factors affecting a bond’s value include:

  • Term to maturity. This is the length of time before the principal is repaid by this issuer. In general, the shorter the term to maturity, the lower the risk of interest-rate fluctuations and longer-term bonds pay higher rates of interest because they’re exposed to more risk.
  • Credit rating. The credit-worthiness of the company issuing the bond indicates the likelihood your principal will be repaid and that scheduled interest payments will be uninterrupted. It makes sense that the greater the risk of default by the issuer, the higher the interest it must pay to the lender or bond investor.
  • Interest rates. Interest rates and bond prices generally move in opposite directions: When interest rates are falling, the market price for existing bonds will rise since their relatively higher rate of fixed income becomes more attractive to bond buyers. Conversely, when rates are rising, existing bonds become less attractive because of their relatively low interest rates, and the bonds with higher rates would be in greater demand.

A bond fund represents a managed portfolio of individual bonds and, as with all mutual funds, offers the benefits of diversification and professional management to investors.

Most bond fund managers aim to adjust the fund’s holdings according to interest-rate changes. The manager’s outlook for the market – in particular, where interest rates are headed — determines the fund’s holdings at any given time. By actively trading the bonds in the portfolio — remember that bond prices will fall when interest rates are rising and vice versa — a fund manager hopes to create capital gains for the fund. Naturally, the wrong call on the direction and degree to which interest rates move means that the fund will lose money.

In contrast, if you buy a bond issued by a well-established, credit-worthy company or guaranteed by government and hold it to maturity, you can be pretty confident of getting your principal investment back.

However, in addition to the potential for capital gains, a major advantage of bond funds is that they are more accessible to smaller investors than bonds are. You can invest in most bond funds with as little as $500, and you can buy in with even less if you agree to make regular, periodic investments in the fund family. Bonds, on the other hand, are sold in fairly large denominations. With minimum investments typically around $5,000, it can be difficult for smaller investors to hold a diversified portfolio of bonds.

Remember, though, that you pay for the benefits of bond-fund investing in the form of management fees; especially at times when bond-fund returns are modest, the impact of these management costs can be significant.