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Are you with the right bond fund? - Views on News from Equitymaster
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  • Nov 5, 2001

    Are you with the right bond fund?

    Bond funds have been a rage over the last one-year, as returns have outstripped even the most optimistic of expectations. However, investors need to be very careful while selecting a bond fund.

    Here we outline some critical points you should consider before choosing to invest in a bond fund.

    • Asset allocation: An income or a bond fund invests its assets primarily in corporate debt, government securities and money market instruments. Investors need to evaluate the volatility of the investments. For example, prices of government securities (gilts) at times can be very volatile, and this leads to higher uncertainty i.e. more risk. A well-diversified portfolio is a strong positive.

      In our illustration above, XYZ Income Fund has 19% in gilts, 36% in corporate debt, 40% in public sector debt (companies/financial institutions) and 5% in cash/call. This is a reflection on the fundís strategy, by taking a lower exposure to gilts, the fund has curtailed interest rate volatility. By taking a higher exposure to bonds, it has stuck to its basic objective of investing in bonds.

    • Rating profile: The investor should see that the asset allocation of the portfolio in line with the rating allocated to the securities. Look out for securities with ĎAAAí rating, as this will reduce the credit or default risk.

      XYZ Income Fund has 73% exposure to AAA-rated securities and 19% exposure to gilts, which have a sovereign rating. This is a very solid portfolio as far as the rating goes. With only 3% in AA-rated paper, the fund manager has taken very little risk.

    • Maturity profile: Investors need to see the maturity profile of the fund portfolio. See the maturity breakup of the securities and look out for paper that is at the lower end.

      XYZ Income Fund has about 40% in less than 3 years and 38% in 3-5-year paper. This is a conservative strategy as the fund manager does not want to comprise on the liquidity and stability of the fund by taking excessive exposure to longer-dated paper (more than 5 years), which could add to volatility. It has 17% in more than 5-year paper, which is reasonable and should not disturb the fundís stability.

    • Average Maturity: The most important point an investor should consider is the average maturity of the instruments in the portfolio. A bond fund having an average maturity at the lower end of the market say 3-4 years is less volatile than a fund have an average maturity at the higher end of the market say over 5 years. The reason for this is an instrument having low maturity carry a low coupon rate and vice versa, so any change in the interest rate has less effect on the price of the instrument of low maturity than the higher one. This is because there is an inverse relationship between the bond prices and the interest rate, when the interest rate fall the bond prices move up and vice versa.

    • Performance: An investor should always look at the returns given by the fund over a period of time. The time frame for judging a fund should be at least 3 years wherein in the investor can judge whether the fund has been consistent in its performance. If an investor wants regular income he/she should look at the dividend history of the fund wherein he/she can get an idea of the consistency of the dividend declared. Which option is best to invest for growth, dividend payout, or dividend reinvest to know more about it click here.

    • Corpus: The total corpus of the fund is also very important, as they are more diversified and less prone to market risk. Also they have the advantage of investing in the big initial market issues. Larger funds offer high liquidity as they are in a position to meet sudden redemption pressure.

    • Minimum/Additional investment: The minimum investment encourages a small investor to invest in bond funds. The minimum investments in a bond fund ranges from Rs 1,000 to Rs 5,000 subject to an additional or subsequent investment, which ranges from Rs 500 to Rs 1,000. There is also an option of systematic investment plan, to know more about them click here.

    • Load: Load is what an investor has to pay either at the time of entry in the fund or at the time of redemption. Bond funds generally donít have entry load but most of them are subject to an exit load. A good bond fund has an exit load of 0.25% to 0.5% if redeemed within 3 or 6 months. An investor should avoid a bond fund having a higher load structure than stated above.

    These are the most important points, which an investor should definitely consider and take his decision on a right bond fund.

    If you are in Mumbai and are interested in mutual funds or other investment products, please register here.



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