(1) Do not focus only on income--find a fund that meets your income needs, yes, but also make sure that it delivers competitive total returns.
(2) Costs matter, in a big way—bond returns can be relatively low, so over time low cost funds have a decided advantage over higher-cost ones.
(3) Bond funds become more sensitive to changes in interest rates and more volatile as their durations lengthen. Make sure the “rate risk?of the fund you choose is within your tolerance.
This week, I’ll highlight several more factors you can use to make sure you select the right bond fund to meet
your needs.
If a fund’s income stream looks too good too be true, it likely is: Bonds represent promises by companies to repay the money used to buy the bond at a specified future date, with interest payments along the way. Just like individuals with shaky finances, companies with poor credit must pay higher interest rates to persuade bond buyers to lend them their cash. This means that funds can boost their income payouts by purchasing bonds from issuers with lower credit-quality ratings, but doing so exposes your fund to the potential for capital losses if the credit quality of the issuer(s) in question continues to deteriorate, or—in the worst case scenario—if the issuer defaults. Funds with large exposures to such issues also tend to be more sensitive to economic cycles than are funds focused on higher quality fare.
High yield funds specialise in bonds with a high degree of credit risk, but other funds may hold more than you think in such issues. Be sure to ask your adviser how much credit risk your bond fund is taking on. Many bond funds in the UK fail to report this critical information, but you should demand it before you invest.
Currency Exposures
Bond funds can either focus on giving investors exposure to a particular currency, as is the case with funds in Morningstar’s sterling diversified bond category, or they can give exposure to a range of currencies. A fuller disclosure of a bond fund’s currency exposures can be found in its long-form annual report. Most UK investors will want Sterling exposure, but if you have a need for exposure to other currencies, you can purchase funds that offer it. Funds with unhedged exposure to foreign currencies will expose the fund to the risk of unfavourable movements in the exchange rate. These can be hedged out by the fund manager, while still retaining exposure to foreign bonds, via the use for forward currency contracts.
Sector Exposures
Bond funds may invest in a single sector (e.g., UK Gilts), or across multiple sectors, including asset-backed debt, foreign government debt, inflation-linked debt, and corporate debt, just to name a few. Some sectors (the debt of developed countries, for example) can be quite safe, but concentration in others can heighten a fund’s risk. Investing in mortgage-backed securities, for example, may expose a fund to prepayment risk in a falling rate environment (this is the risk that borrowers will repay their mortgages earlier than expected, leaving the bond-holder to reinvest the proceeds at a lower rate of interest).
