Individual bond investments and bond mutual funds: Reality vs illusion
A bond is a typical fixed income security that offers a fixed or guaranteed rate of return to the investor over a specified period of time. Nevertheless, the risk and return characteristics of individual bond investments vis-a-vis bond mutual funds are not the same. Depending on the peculiar investment objectives, some fixed income investors will benefit the most from individual bond investments while others benefit significantly from bond mutual funds. A thorough understanding of the two is essential to help fixed income investors to choose the right investment vehicle that meets their investment objectives. This article compares some associated risks of individual bond investments and bond mutual funds.
Understanding Individual Bond Investments and Bond Mutual Funds
A bond is a fixed income instrument that indicates debt obligation of the issuing entity usually governments and large corporate bodies. In simple terms, when an investor purchases an individual bond, he or she is basically lending money to the issuing entity in return for the payment of specified interest over the tenor of the bond. On maturity, the issuing entity returns the initial invested principal to the lender. It is worth noting that, the prices of bond may fluctuate during its tenor. Nevertheless, an investor who intends to hold an individual bond investment to maturity does not lose anything provided the issuer of the security remains solvent over the tenor of the security. On the other hand, bond mutual funds involve investment in a portfolio or underlying collection of bonds. Bond mutual funds managers invest in different portfolio of bonds ranging from government bonds to corporate bonds. Also, bond mutual funds may consist of portfolio of bonds with different maturity dates ranging from short term to long term. Typical examples of bond mutual funds in Ghana are EDC Fixed Income Fund, Fidelity Fixed Income Trust Fund, STANLIB Income Fund, and Omega Income Fund among others. As stated earlier, bond prices remain volatile over their tenor due to fluctuations in the prevailing market interest rates. Unlike individual bond investment that pays periodic interest and returns the invested principal to the holder on maturity, the value of bond mutual funds depends on the Net Asset Value (NAV) of the entire underlying bonds in the portfolio. The fluctuations in the bond prices therefore affect the NAV of bond mutual funds. Thus, bond mutual fund investors are likely to lose portion of their invested principal especially during periods of rising interest rates.
Comparing the risks of individual bond investments vs. bond mutual funds
The future cash flows of an individual bond from coupons and principal payments are predictable with the only caveat of insolvency. In the case of a bond mutual fund, because the underlying holdings are bought and sold, there are fluctuations in the NAV of the fund. This renders it practically impossible for an investor to accurately predict his or her stream of cash flows. Though the past performance of the bond mutual fund can form a basis for investment decision, it is however not a sure guarantee of future performance.
Interest rate risk is one of the main risk of bond investment. It is the risk that arises as a result of changes in the prevailing market interest rates which ultimately affect the price of bonds. The price of a bond is inversely related to the interest rate. The higher the interest rate, the lower the price and vice versa. Interest rate risk is therefore a major concern for fixed income securities that are bought with the intention to sell. Individual bond investment bought with the intention to hold to maturity is immune to interest rate risk. On the other hand, bond mutual funds are automatically affected by interest rate risk mainly due to the buying and selling pressures from the fund. The NAV of the fund falls when interest rates are rising. Bond mutual funds investor lose money in this scenario while individual bond investors are protected in such instance. During periods of declining interest rates, the prices of the underlying portfolio of bonds in the mutual funds rise, causing the NAV of the fund to rise. Bond mutual funds investor make extra money which the individual bond investor cannot make until the bond is sold on the market which is the Ghana Fixed Income Market (GFIM) in the case of Ghana.
Also, with individual bonds, as long as the issuer does not default, the investor is assured to receive the bond’s par value when it matures. A bond mutual fund on the other hand does not have specified maturity date and its value is subject to fluctuations depending on the buying and selling pressures of the fund. While bonds prices can fall which can affect the bond mutual fund, an individual bond investor has the option to wait until it matures to receive the par value or the full principal.
Bond mutual funds are generally diversified across multiple securities. This reduces the risk exposure compared to an individual holding bonds issued by a single entity. This can help lessen the downside impact from a credit event impacting any one of the issuers. Nevertheless, an individual bond investor can also enjoy a diversified portfolio by investing in bonds by different issuers or investing in different maturity tenors by the same issuer.
The issue of liquidity risk can be more aggravated with an individual bond investment than bond mutual funds. In some cases, there may not be an active 2-way market for a specific bond and the price discovery process could take several hours. With a bond mutual fund, the investor has access to either buy or sell from the investment at the end of the day, easing liquidity for the investors.
Finally, all other things being equal, bond mutual funds benefit from the services of professional management team, skilled in assessing and analysing market conditions to make informed investment decision. They are therefore able to leverage their expertise to invest in bonds that are on the market to improve the NAV of the fund. This expertise comes at a cost such as management fees and transaction charges on purchases and sales from the fund. On the other hand, individual bond investment may not enjoy this expertise unless the investor himself is skilled in the financial market. In some cases, unskilled individual bond investor may engage the services of a professional in selecting the right investment at a fee. An individual bond investor who buys or sells bonds on the open market incurs transaction charges usually priced in the dealer’s quote.
Though Individual bond investment and investment in bond mutual funds are both fixed income investment securities, they have different risk and return characteristics. A thorough understanding of the two is essential to help fixed income investors choose the right investment vehicle suitable for their investment objectives.