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Benefits / Negative aspects of bonds, Screenshot 2020-11-10 at 22.37.29 -…
Benefits / Negative aspects of bonds
Benefits
Given that bond funds can usually invest in a number of different bond types and classes, this provides diversification so that while the investment type is specific, the bonds that may be held are varied to provide risk mitigation from a concentration perspective
If there is one particular bond in the portfolio the is underperforming then the overall impact of that is reduced because of others in the portfolio helping to balance the peerformance
From a investor perspective, there is also the additional consideration of whether the income is automatically reinvested
Investors will need to ascertain this when looking at potential bond funds as if it is reinvested, then the value of the fund is consistently added to for further investment in bonds which can be a positive in favour of the fund but may also mean that no dividends within the investment period are paid out to investment - resulting in no ongoing income from the investment within the investment period
Bond funds can provide a particular attraction for those that wish to invest in bonds but not want to be tied in directly to a bond themselves eg they may want exposure to a particular bond but the life span of it is too long for their needs, this can be addressed through a fund as if the fund is open ended you can see your shares at any time without being affected by the bond maturity date
Negative aspects
Fees which are applied to funds by the parties involved such as fund admin, which are ordinarily a % of the fund vale, which would not be payable if you held the bonds directly yourself
Variable dividends - bond fund dividend payments may not be fixed in the same way that they would be with the interest payments of a bond that is held directly leading to potential fluctuation of the value of dividend payments each time they are paid, linked to the type of the bonds within the portfolio
Variable NAV - the NAV of the fund may change over time whereas this does happen with an individual bond in which the total issue price will be returned upon maturity so long as the bond issuer does not default
There are no guarantees when investing in a bond fund, even if the individual bonds in the fund are guaranteed by the government or even insured through a private insurer, the value of a bond fund can still rise or fall
Risks to investors
Interest rate risk
The possibility that a bonds price will change due to a change in prevailing interest rates
Bond prices are correlated to a rise or fall in interest rates
When rates go up, most bond prices go down
The longer a bonds reamining maturity then the more its price will tend to fluctuate as interest rates change
While longer term bonds tend to fluctuate in value more than short term bonds, they will also generally offer higher returns as a result of the additional risk that the investor is taking
Credit risk
Refers to the creidtwrothiness of the bond issuer and its epxected ability to be able to make interest payments on time and to pay the face value of the bond at maturity
Bond funds which contain government backed bonds will use less of a credit risk than those issued by private corproates
If a bond issuer is unable to repay the capital or interest on time, the bond is said to be in default
A reduction in an issuers credit rating can cause the price of bonds to decline and could then impact upon the share price of any bond that holds that issuers bonds so that they decline as well
The creditworthiness of any issuer is usually derived from a bond credit rating issued by one of the credit rating agencies
Two of the most well recognised agencies are Moody's and Standard and Poors
If the underlying bonds have been allocated a good credit rating by the agency, this will ensure a good credit rating of the fund, assuming all bonds within it are of a similar standing
Inflation risk
Investors can be attracted to bond funds because of their regular dividends from interest earnings
The dividends can be subject to inflation risk
Inflation erodes the return of any investment
If investments pay out a fixed return of interest over a set period of time, such as bonds or CDs do, as inflation increases, investors will discover that the fixed amount they receive back has less buying power and therefore its value is eroded
The longer a bonds maturity, the greater its inflation risk as over time inflation may fluctuate more significantly than can be anticipated
When calculating bond returns, issuers will often incorporate expectations of inflation so that investors are compensated for expected inflation risk
If inflation rises by more than wa expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had antipcated
Prepayment risk
When a bond owner has their initial capital returned back to them by the issuer before the bond's maturity date is reached
This tends to happen when interest rates fall and the existing bond they have in issue if paying above market rates and therefore ceases to be a cost effective means of borrowing for the issue
In these circumstances borrowers will often issue bonds or obtain loans at the new lower interest rates and use the proceeds that they raise form that to prepay other debt with higher interest rates
For example, a company may issue bonds when there is a drop in interest rates so that they have funds available to pay off callable bonds at their next call date.
A callable bond is one where the issuer has the right to redeem the bond before ts stated maturity date and the investor has no right of refusal. As a consequence of the prepayment, the bondholder will not receive any more above-market interest payments from the investment. Wherever prepayment occurs, it forces investors to reinvest their funds into a market where interest rates are lower than the rates they had previously been receiving from the bond that has been prepaid. Nevertheless, firms issuing callable bonds generally pay higher interest rates for the right to pay back the bond before maturity.
