If you are an investor who demands diversity in your portfolio, don’t overlook the important diversification benefits that fixed income may bring to your overall strategy. While stocks are about living well; bonds are about sleeping well.
When should one start investing in Bond/Income Funds?
This mostly depends on the following Macro Economic Indicators:
India has started witnessing slowdown in the economic activity on account of global slowdown.
We expect the Fiscal deficit, the current account deficit and Indian Rupee depreciation to peak out in the current financial year (FY ‘09).
In light of this, the central bank shall adopt an expansionary monetary policy & build a softer interest rate regime.
Over the period of 12-18 months, we expect the benchmark 10 year bond yield to come down by 100 basis points.
The current credit spreads of around 350-450 basis points are very high as compared to the normal level of 150-180 basis points. Hence, we expect spreads to come down by 200 basis points in next 3-5 months as the dust settles around the global credit crisis.
Thus, the expected economic scenario and monetary policy expectations indicate lower interest rates going forward. We believe it presents a good investment opportunity for the investors to lock in the current high rates by investing in short term and long term debt funds.
THE BENEFITS OF BOND/INCOME FUNDS:
• Bonds generally provide investors with attractive levels of monthly income, or the interest may be compounded for potentially greater future returns.
Potential capital preservation
• Generally bonds are less volatile than stocks, which may mean limited losses that could help preserve your wealth.
Potential capital appreciation
• Bonds may also become more valuable if and when interest rates decline or when the issuing business improves – giving them the potential for appreciation.
• Bonds may help to protect your portfolio during stock market declines or times of tepid equity returns. Since stocks and bonds don’t usually move in tandem, bonds may provide added diversification.
Components Affecting Bond/Income Funds:
– Interest rates
When interest rates rise, bond prices usually fall. And, when interest rates fall, bond prices usually rise. Accordingly, bond prices are affected by market conditions and interest-rate fluctuations. However, market risk is diminished somewhat for holders of bond funds as compared with holders of individual bonds, but it can influence the value of a bond fund investment.
– Inflation risk (loss of purchasing power)
A high rate of inflation can reduce the purchasing power of income from a bond fund investment. For this reason, investors who have a long time horizon before needing to use income from their portfolio generally direct a small portion of their investment to bond funds and a larger portion to stock funds. Then, as the time to depend on the portfolio’s income stream approaches, the investment to bond funds may increase.
– Credit risk
Bond issuers vary in their creditworthiness, since issuers differ in their perceived ability to repay a loan at maturity and to pay interest.
Of course, bond funds are not stable value investments and involve risk. Their value is affected by changes in the direction of interest rates. As interest rates rise, bond prices decline, and vice versa. But in reality, both rising and falling interest rates can offer advantages to bond investors.
When rates rise, bond prices can be expected to fall, yet higher rates can mean higher returns on reinvested bond income.
When rates fall, bond prices can be expected to rise, potentially boosting a fund’s return.
What’s the practical application? How should interest rates affect your bond-fund investment decisions?
– You make portfolio decisions based on your goals, your attitudes about investment risk, and the time until you’ll need to begin using money from your investment. If rising rates are a concern for you, remember that a bond fund’s duration (essentially, the average time to maturity of all its holdings) can suggest how interest rates might affect performance. The longer the fund’s duration, the more susceptible it is in the short term to rising rates.
For example, if rates rise 1%:
A fund with a 3-year duration might be expected to lose about 3% of its value.
A fund with a 10-year duration, however, might be expected to lose about 10% of its value.
Bond funds can play an important role because they help to diversify your portfolio and produce investment income.
The bond’s price:
What makes bond investing trickier than it might appear so far is the fact that a bond’s price moves up and down according to market conditions and interest rates.
So an Rs.100 par-value bond might cost Rs.90 – or Rs.110.
If the bond sells for less than its face value, it’s said to sell at a discount.
If it sells for more than the face value, it’s said to sell at a premium.
Of course, if a bond is held to maturity, an investor is paid the bond’s full face value. However, in bond funds, the underlying bonds are rarely held to full maturity, and buying and selling take place all the time.
What causes bond prices to rise and fall? The most influential factor is overall interest rates:
When interest rates fall, bond prices rise, since the coupon or interest rate paid by existing bonds is higher than those of the new bonds being issued. Therefore, investors are willing to pay a premium for them.
When interest rates rise, bond prices fall. In this scenario, investors can purchase new bonds at higher interest rates, so the value of existing bonds falls and they are sold at a discount.
The bond’s yield:
Many people are confused about the difference between a bond’s yield and its coupon, or interest rate. Yield is defined as its coupon amount – not the coupon rate – divided by its price.
The rule: when a bond’s price raises, its yield drops. When its price falls, its yield rises.
Risk Characteristics of Fixed Income (Bonds)
Exposure to financial, market, prepayment and interest rate risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. The principal risks of bond investing include increases in interest rates and default risk. Generally, when rates rise, bond prices fall. Bonds with longer maturities and durations tend to be more sensitive to changes in interest rates than bonds with shorter maturities and durations.
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