Nov 01 2011
Fixed income unit trust is touted as the safest asset class in unit trust investment. But is it as safe as fixed deposit? The answer is NO. Fixed deposit is a risk-free investment vehicle which guarantees you the return. Fixed income fund does not. So what is the financial workings behind a fixed income unit trust?
Fixed income fund invests in bonds. In this article, the terms fixed income fund and bond fund will used interchangeably.
Bond is a fixed income securities. If issued by private sector, it is known as corporate bond. It is considered a debt instruments to raise capital to finance expenditure or working capital, without diluting the ownership rights (unlike shares).
From investor perspective, they will lend an amount of money to the bond issuer, and in return they will get a predetermined rate of return (coupon payment, usually within 5 to 10 percent) from their capital annually/semi-annually/quarterly. In addition to this, the capital will be repaid to the investor when the bond ‘matures’, normally within 1 year for short-term bond (aka Treasury Bills) and 10 years for long-term bond. The initial committed principal may be less or more than the final capital repayment, the former known as discount bond and the latter as premium bond. In short, investor is guaranteed to be compensated in periodical coupon payment in addition to the value of discount of the bond ‘price’.
Systematic risk refers to the investment risk associated with the local and global economic conditions. This, more often than not, is the primary risk for government bonds.
The net asset value (NAV) of a bond fund which largely consists of a portfolio of government bonds fluctuates according to the economy. This type of risk is something no one can control, but perhaps more predictable. You will know an economic recession is looming in the horizon by keeping up to date with a lot of economic indicators such as interest rate, purchasing manager index and business condition index.
Government bonds are almost similar to risk free investment, unless you are living in nation like Greece where government could default on its nation’s debt. United States, for example, has a sterling bond rating of triple As until it is downgraded this year.
The more unpredictable risk inherent in a bond fund is unsystematic risk. This type of risk relates to an organization or corporation which issues the bond. It is more likely for a company regardless of its size, if the company is being mismanaged. The analogy of it is this. I accumulate a sum of money from my family members and purchases bond from you. You are the corporation which issues me the bond and I am the mutual fund itself, while my family members are the bond unit holders (investors). You take the money to gamble, and in the end losing all of it. As a consequence, you can neither repay me the principle nor the periodic coupon payment. The fund goes down the drain along with the investors’ money when the bond issuer defaults on its financial obligations.
How to mitigate the risk
Whichever bond fund you choose to invest in, take time to read their financial reports twice a year. One is annual report, issued after the end of the fund’s fiscal year, and another one is interim report. This may sound tedious if you are not a finance guy; but trust me, this is something you can do in 30 minutes. You probably spend more time planning for your vacation, what is the rationale of not spending a fraction of that time flipping through the annual reports when your money is at stake here?
Focus on the bond holdings of the fund. See if the objectives and mandates of the fund has changed. The mandate can mean the lowest grade bond category a fund manager can hold or buy for the fund. Any bond has its own rating which reflects the credit worthiness of the bond issuer. In layman terms, the higher the rating, the least likely bond issue is to default. The rating is evaluated independently by agency such as Standard & Poor’s. Ensure that all bonds held in the fund are of investment grade (BBB and above). Any bond holdings below this grade are considered junk bonds and should be a red flag. Redeem your cash and look for some other funds instead. It is not worth to risk your money in junk bonds which may promise higher yield.