Investing in a bond fund (also referred to as income fund) can be quite a challenge for the lay investor. There are several factors he needs to consider, which requires good insight in the working of a bond fund. We have tried to list down some of these factors to enable you to make an educated choice while selecting a bond fund.
Step 1. Evaluate the asset allocation
A bond fund invests primarily in corporate debt, government securities and money market instruments. Investors need to evaluate the asset allocation of the fund to gauge volatility in the fund. For example, prices of government securities (gilts) in times of economic and political turbulence can be volatile, and this leads to higher uncertainty i.e. more risk. A well-diversified portfolio is a strong positive. (How will bond funds fare in 2003? Download our FREE Guide to find out)
The Ideal Bond Fund has 25% in gilts, 70% in corporate debt (including financial institutions) and 5% in cash/call. This is a reflection on the fund’s strategy, by taking relatively 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.
Step 2. Evaluate the 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 ‘AAA’ rating, as this will reduce the credit or default risk. Sandesh Kirkire (VP - Debt, Kotak Mutual) one of the leading debt fund managers in the country today concurs, ‘From a lay investor’s perspective, I think the most critical thing is the quality of the portfolio. The investor should see the rating profile of the debt securities invested by the fund.’
The Ideal Bond Fund has 60% exposure to AAA-rated securities and 25% exposure to gilts, which have a sovereign rating. With 85% in AAA/sovereign, this is a very solid portfolio as far as the rating goes. Even with 15% in AA-rated paper, the fund manager will have taken minimal risk to ensure a high level of credit quality.
Step 3. Evaluate the 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 of the yield curve.
The Ideal Bond Fund has about 40% in less than 3 years and 35% in 4-6-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 6 years), which could add to volatility. It has 15% in 6+ year paper, which is reasonable and should boost returns in times of falling yields.
Sandesh explains how fund managers use various instruments to adjust the maturities, ‘Maturity is normally controlled through investments in gilts which are normally at the longer end while the investments in corporate debt is normally at the short to medium end. Depending on the interest rate view of the fund house, the fund manager increases the fund’s average maturity or shortens it mainly through the gilt route.’
From a risk perspective, one important point an investor must consider is the average maturity of the fund’s portfolio. A bond fund having an average maturity at the lower end of the market say 4-6 years is less volatile than a fund with an average maturity at the higher end of the market say over 6 years. What is the ideal average maturity for a bond fund? Sandesh explains, ‘There is no standard maturity. Funds tend to increase or shorten their maturity portfolios depending on their interest rate view.’
Step 4: How has it performed?
Look at the returns given by the fund over a period of time – at least over 12 months to get a fairly good idea and 36 months to judge consistency in performance. If you want to evaluate its dividend-paying track record then look at the dividend history for consistency.
For the lay investor who is unable to independently evaluate the bond fund manager’s investment strategy vis-à-vis interest rate movements, returns serves as a reliable benchmark. Sandesh asserts, ‘I think an investor should mainly look at the average rolling return for 6 months to a year over a longer period, for him to get the comfort on the return expectations. Most of the fund managers do indicate the return expectation over the next six months to a year so as to give a realistic expectation to the investor.’
Bonds funds come with various options - short-term plans, long-term plans and so on. For the lay investor the idea is to match his investment horizon with the plan. Sandesh advises, ‘I think the lay investor should invest in the debt schemes looking at his investment horizon. For short-term horizons he should look at investing in the liquid (for a 1 month horizon) or the short term bond plans (for 1-6 months). For horizons above 6 months he should look at the bond schemes or the long term gilt schemes.’
These are some of important pointers you need to keep in mind while investing in a bond fund. Hopefully, investors who are cautious enough to consider these factors will have grown older and richer.
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