Selecting appropriate bond funds

  • Business
  • Monday, 18 Aug 2003

THE 1997 Asian financial crisis, the 2000 technology sector sell-down, Sept 11 terrorist attacks, followed by Bali bombing, and another Gulf War have quashed investors' confidence in equities time after time. Most have turned to bonds and time deposit as alternatives.  

According to Lipper, bonds have been the best asset class, returning 58% between January 1998 and June 2003. However, unlike stocks, most investors are not able to gain direct exposure into the local bond market. Most investors choose bond unit trust funds instead. 

Which is the right bond fund? How do you choose? With the recent pullback in global bond market, is there any more upside for bonds? If yes, what are the risk factors and how do you know when to buy or sell? The following are some critical (but non-exhaustive) points to consider.  

Bonds have an important role to play in one’s portfolio. They tend to provide a stabilisation effect and offer strong diversification benefits with equities. An investor may want to select an appropriate bond fund that complements his overall portfolio. For example, an investor who is overweight in equities may want to consider high-grade investment bond funds (Ratings> single A), as they have a stronger negative correlation with equities.  

Similarly, if an investor already has a sizeable proportion invested in high-grade bonds, he may want to consider high-yield bond funds (Ratings < single A) investing in riskier credit papers. Adding more high-grade bonds may not offer any diversification benefits, but they enhance returns without significantly increasing risk.  

Malaysian bond unit trust funds are confined to ringgit fixed-income securities in their investments. Also, the bond market in Malaysia is lumpy and as such, rather illiquid. Large bond funds may find it relatively more difficult to trade compared with a smaller bond fund.  

This could mean differences in performance return. As witnessed by bond market events in July 2003, it would be harder for the larger bond funds to take advantage of tactical opportunities, position themselves quickly, change management style or to sell their bond holdings quickly for that matter.  

But the smaller bond funds would have poorer diversification benefits (probably holds only a few papers) compared to the larger bond funds, although easier to trade.  

Newly-launched bond funds do not have a tested track record. Investors may want to look at a fund’s track record, and assess its consistency in delivering returns. Some methods include looking at rolling period returns and consistency in outperforming peer group average (e.g. Lipper consistency return score).  

In Malaysia over the past few years, there have been some newly-launched bond funds that have performed well in the short term during the bond market rally. But the managers may lack experience and have not been tested in managing during difficult times.  

Bond funds do not consistently post positive returns over a period. As with all investments, bond fund returns may fluctuate and may even be negative. Investors should check with their investment adviser about the volatility of bond fund returns often measured by the standard deviation of returns. The risk or volatility figure should provide some form of gauge on the maximum potential loss for a particular fund.  

Other risk factors pertinent to bond funds include duration risk or interest rate risk and default risk. Due to these factors, not all bond funds have identical risk. Bond funds with longer durations are more sensitive to changes in interest rates change and can rise significantly in value when rates drop or lose value when rates rise.  

Bonds with lower credit qualities pay higher yields to compensate for default risk. Funds with large holdings in high-yielding bonds are particularly superior as economic growth accelerates but vulnerable as economy weakens. One should thoroughly assess these risks in a bond fund and whether the investor is comfortable with that level of risk given the expected return.  

Bond funds can be affected by cyclical factors like interest rate movements and inflation expectations. As such, the longer one invests in bonds, the higher the risk, given the longer the period the fund is exposed to these factors. A bond fund’s recent performance can differ from its long-term average returns.  

Studying the difference between the two can be helpful. If recent returns are low compared to its long-term average, and the investment process or fund manager remains unchanged, then the potential for upside may be greater. Conversely, if prices are high, the chances of a correction are also high, and investors should be cautious.  

When buying bond funds, note that dividends are only half the picture. Total returns, that is, what investors receive from both capital appreciation and income distribution, tells a more complete story. For example, one unit of bond fund X, which costs RM10, pays 4% in income per annum. Over one year, the price rose to RM10.50. This means that the total return was 9%. On the other hand, bond fund Y pays 8% dividends but the price fell to RM9.50.  

The total return in this case was just 3%. So, unless you are in need of regular income, you should consider choosing a bond fund that balances both income and growth.  

Bonds tend to perform conversely to equities. In a bull equity market, bonds may underperform equities with smaller returns. In the initial stages of a bear equity market, the safer government bonds and higher grade corporate bonds may be preferred.  

Thus, these papers may lead the gains in the initial stages. As these papers get snapped up and reach fair valuation, investors switch to riskier bonds (either via longer duration, or riskier credit) to enhance gains. As the economic situation worsens to a point where interest rate is lowered, the longer duration bonds could outperform. 

Most investors perceive that during bond market correction, all government or corporate bonds should be avoided. This may not be entirely accurate as it depends on the economic cycle and type of bonds. Similar to a situation where some investors consider switching to high-dividend defensive stocks during bear equity market to minimise capital loss, not all bonds suffer price decline simultaneously. 

As the bear market for equities ends, and the rally in bonds slows, poorer credit rating corporate bonds (< single A rating) could now see the better returns as the economic situation improves and these formerly poor credit pa- pers see a positive re-rating. In Malaysia, the limited issue size in this segment may mean that a slight demand improvement may push yields lower or prices in this segment higher.  

In short, investors need to identify where they are in the economic cycle to better play the market and take advantage of short-term tactical moves to enhance returns.  

Identifying where they are in the cycle may help identify threats and opportunities. After all, we have said earlier that bonds play an important stabilisation role in investment and should not be entirely left out of one’s portfolio.  

·The above views reflect those of Citibank Bhd as at the date of publication. They are intended for general information and/or discussion of the topic. They are not intended to be relied on in any way by any investor in foreign currencies or other investment products.  

While every effort has been made to ensure accuracy of the information, no liability whatsoever will be accepted by the bank or the author whether in contract, tort or otherwise, for any error of fact or omission herein which may lead to any direct or consequential loss arising from any reliance upon or the use of this report. Investors should seek independent professional advice before making any investment or taking any course of action towards investing. 

A copy of the valid prospectuses of the unit trust funds distributed by Citibank have been registered and lodged with the Securities Commission. Applications for unit trusts may only be made on forms of application available with the prospectuses. A copy of the prospectuses can be obtained from Citibank by calling (03)2383 8833, (04)227 6666 or (07)276 8833. If you have any feedback on our articles, please email us at cis.malaysia 

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