Bonds - an attractive asset during economic uncertainties

Investors seeking regular income should consider investing in fixed income funds which
can provide higher returns than fixed deposits and are ideal for adding diversification to an
investment portfolio. In fact, during times of economic uncertainties such as slower global
economic growth, fixed income assets generally tend to perform better than equity assets
as bond prices will be well-supported in a low inflationary environment. Moreover, the
lower volatility of fixed income returns provides investors with greater stability in their
investments over time.
Fixed income funds invest in a portfolio of bonds, debentures and money market
instruments. This article highlights one of the most common fixed income fund offered by
unit trust companies bond funds.
Definition of a Bond
A bond is a type of security that functions like a loan. Bonds are I Owe Yous (IOUs)
issued by private companies, municipalities, or government agencies. The money used to
subscribe to a bond is lent to the issuer in other words, the company, municipality, or
government agency that issued the bond. In exchange for the use of this money, the issuer
promises to repay the amount loaned (also known as the face value of the bond) on a
specific maturity date. In addition, the issuer typically promises to make periodic interest
or coupon payments over the tenure of the bond.
After a bond is issued to the primary subscribers, it may be traded in the secondary bond
market. The price at which a bond trades, however, may fluctuate as bond prices move
inversely to changes in interest rates. When interest rates fall, a bonds value usually rises
thereby generating a capital gain for the bond. Alternatively, when interest rates rise, a
bonds value usually falls thereby resulting in a capital loss on the bond.
Bond Funds
Bond funds invest in a portfolio of bonds with various maturities, issued by federal,
provincial, and municipal governments as well as major corporations. The aim of a bond
fund is to provide investors with income and/or capital gains from a diversified portfolio of
bonds. An investor can compute the return on his bond fund by monitoring the movement
in the funds net asset value (NAV).
One of the biggest advantages of bond funds is the diversification that can be obtained with
a small pool of investible funds. Instead of purchasing an individual bond, which can be
rather costly, investing in a bond fund allows an investor exposure to several bonds from a
variety of issuers with varying interest rates and different maturities.
Unlike an individual bond, a bond fund does not give a fixed rate of interest. The
distribution paid by a bond fund fluctuates depends on the income generated from its

portfolio of bonds. A bond fund generates income from the interest or coupon received and
the capital gain, if any, resulting from interest rate changes. One of the tasks of the fund
manager is to capitalise on the changing interest rate environment. To optimise returns, a
fund manager will position the bond portfolio by holding bonds with longer maturities
during period of declining interest rates and switch to shorter maturity bonds when interest
rates are rising.
A bond fund also does not have a fixed maturity. However, a bond fund has an average
portfolio maturity, which refers to the average maturity dates of all the bonds in its
portfolio. In general, the longer the funds average portfolio maturity, the more sensitive its
NAV will be to changes in interest rates. Nevertheless, bond funds that have longer
average portfolio maturities tend to offer higher yields to compensate investors for the
higher interest rate risk.
Risk versus Reward
Like all unit trust funds, investing in bond funds involve investment risk, including the
possible loss of principal. Nevertheless, when you make an informed decision to assume
some risks, you also create the opportunity for reward. Investing in bond funds usually
entails less risk and more moderate returns as compared to investing in equity funds.
However, the expected returns for bond funds are higher than the expected returns for
money market funds or fixed deposits.
Investments in bond funds are subject to interest rate risk and credit risk.
Interest Rate Risk
As explained earlier, bond prices fluctuate inversely to changes in interest rates. In
addition, prices of bonds with longer maturities are more sensitive to changes in interest
rates compared to shorter maturity bonds. For example, a decline in interest rates will
cause a larger price increase for a 10-year bond than for an equivalent 5-year bond.
However, while longer-term bonds tend to fluctuate in value more than shorter-term bonds,
they also tend to have higher yields to compensate for the higher risk.
Credit Risk
Credit risk refers to the bond issuers ability to pay interest and to repay its debt. If a bond
issuer is unable to repay principal or interest on time, the bond is said to be in default. A
decline in an issuers credit rating, or creditworthiness, can cause the NAV of a bond fund
with exposure to such bonds to decline. The credit risk of bonds are evaluated by
independent rating services, such as RAM Rating Services, Moodys Investors Service and
Standard & Poors, which publish the bonds credit rating periodically.
For more information, please contact Public Mutuals Hotline at 03-6207 5000 or visit
www.publicmutual.com.my.