Chapter 11 - Bond Funds Flashcards
What is a bond fund
A bond fund is a type of mutual fund - mutual fund’s pool the fund’s of investors seeking to invest these into wither equities or bonds
Bond fund is arguably exposed to a lower level of risk than an equity fund due to the known and expected payment and known redemption of underlying value (depending on rating of the bond )
Available to all types of investors
What is a bond
Tradable debt instrument - fixed coupon, redemption date and repayment of capital
Issued by both governments and companies to raise capital
Rating of a bond is linked to the ability of the issuer to meet obligations, government bonds (depending on issuer) deemed more secure than corporate bonds
Different types of bonds
Straight bond - average bond, pays coupons at regular intervals, fixed life and the end of which capital is repaid
Convertible bonds - provided issuer with the option to convert capital into shares of the company at maturity (shares of equal value to bond nominal)
Callable bonds - issued has right to redeem bond before maturity, issuer has no right of refusal. Holder no longer receives benefits of bond
Term bonds - can be redeemed at an earlier date than other bonds issued at the same time. Issuer can redeem at specific times and predetermined price before maturity
Junk bonds - high yield bonds, low credit rating. Rating lower than BB
Angel bonds - issued by companies high credit rating - opposite to junk bonds, lower interest rates paid
Day count convention
Coupons are paid on specific dates - when bond is sold at a date in between coupon payment date, the buyer has to compensate the seller for lost/ accrued coupons
This convention is used to calculate how to apportion the coupon in these instances
Bond duration
Funds can invest into bonds with different maturities - longer bonds are subject to greater fluctuation in terms of bond prices, however, they tend to pay out a higher coupon than short dated bonds
Issuer pays a premium for the benefit of having access to funds for longer
The bond fund itself may have a specific duration itself - gives investors certainty of how long funds will be locked in for
During the life of the fund new bonds will be bought (mix of long/ short) as long as they meet investment parameters set
Duration is a risk in bonds - due to exposure to more price volatility, interest rate and inflation risk
Durations
Short term - up to 5 years
Medium term - 5 to 15 years
Long term - 15 years plus
Main risks associated with bond funds
Interest rate risk
Bond prices and interest rates are correlated - if there is an increase in prevailing interest rate, yields go down
Credit rate risk
Credit risk of the issuer, what is the risk of default? Changes to credit ratings can also affect bond prices, if ratings go down, the prices are also expected to go down.
Inflation risk
Bonds produce steady reliable income, however inflation can erode the spending power of the coupon. It can also erode the value of the capital which is to be repaid at maturity
Prepayment risk
Specific to callable bonds - which can be redeemed before maturity. Usually these pay out higher coupon to compensate for this
Benefits of a bond fund
Diversification
Invest in gin single bond = concentration of risk. Investing in fund = diversified holding
Automatic reinvestment - this may be appealing to come investors
Ability to invest in asset class without being tied to a specific bond
Disadvantages of bond funds
When interest rates are low, fees deducted from fund further erode returns
Variable dividends - although bond coupon fixed, the dividends paid by the fund are not and depend on overall maturities, reinvestment etc
Variable NAV - bond prices subject to interest rate changes, increase of interest rates could drive prices down and spook investors to pull out leading to failure of the fund
