What you should know about the bond fund.
A bond fund is a type of mutual fund. Based on its characteristics (its level of risk and thus its return prospects and recommended time horizon), it is located between money market funds and equity funds.
To understand how a bond fund works, let’s first look briefly at what the bond itself means.
What is a bond?
A bond is a marketable debt security.
If a business, or even a state, needs capital, they can turn to a bank or investors. In the latter case they will issue a bond, in which they undertakes to pay the amount on the bond and its interest on time.
Since the bond is a marketable security, there is nothing to prevent the bond from changing hands.
What is a bond fund?
A bond fund is a securities fund within mutual funds where the vast majority of investors’ money is in bonds.
Here, the fund manager can invest not only in securities specifically called bonds, but also in any debt security. Examples are government securities or discount treasury bills. In addition, of course, the fund manager may, at its own discretion, keep money in a bank deposit with a lower risk than bonds, and may also conduct repo transactions. (In a repo transaction, for example, you buy the bond and then sell it after a certain period of time.)
A bond fund can be an excellent choice for those who want to achieve their financial goals within a period of 1-5 years.
Types of bond fund
Short bond fund
The short-term bond fund has specifically short assets with a maturity of 1-3 years. These have a lower level of risk compared to a long-term bond fund, so they may be a good solution for those looking specifically for their short-term financial goals.
Long bond fund
The average maturity of bonds in long bond funds exceeds 3 years. As the yields on government securities can be said to be completely safe, this bond fund is sensitive to changes in yields on government securities. Investors, of course, prefer a return that is certainly available in the case of rising government bond yields, so that the price of the long-term bond fund decreases, while it rises in the case of declining government bond yields.
Because of this sensitivity, as well as short-term exchange rate fluctuations, it is advisable for those who plan for 3-5 years to choose a long bond fund.
Yield of the bond fund
In terms of yields, let’s first look at the difference between a short bond fund and a long bond fund.
Yield of short bond fund
As I have already mentioned, the short-term bond fund contains assets with a maximum maturity of 3 years, the level of risk is lower compared to the long bond fund, and the yield level is adjusted accordingly.
On the basis of HUF, their typical yield fluctuates around 1% per year, above which you can achieve a higher yield on the basis of EUR.
The vast majority of them are definitely a better solution compared to bank deposits. This way, you don’t have to risk your approach to your goals, but your money still works somewhat. I would not recommend long-term capital building, as its expected return does not exceed the average level of inflation of 3-4%.
Yield of the long bond fund
There is a larger difference (larger variance) in the yield of long bond funds compared to a short bond fund, but their performance is also adjusted accordingly. On an annual average, 3-5% can make this type of investment fund more attractive than before in the eyes of those who can wait for the recommended term of 3-5 years, but do not want to think for a longer period.
Relationship between yield and currency
The development of the return is also influenced by the fact that the given fund invests in domestic or foreign currency (in this case the domestic currency is Hungarian forint). In the picture below you can see how the euro-based bonds were expressed in HUF.
Although you pay domestic currency (i.e. forints) for the unit and you also get back forints, your money works in some other currency, such as euros. Thus, the strength or weakness of the domestic currency also affects the development of your expected return. This is when you pay for 1 euro more or less when investing, and you also get more or less when you take your money out of the bond fund.
The picture below shows the returns of the same investment funds in euros. The difference between the two images was only and specifically caused by the exchange rate change between the forint and the euro.
Bond fund risk
There is no way to list the risks in full for any bond fund, so there may be personal risks that apply only to you.
The list of risks is pretty much like when you buy a box of medicine and read the leaflet in the box. They also list all sorts of risks that can only be considered a little bit. Also those that are not very likely but are still included in the deck.
In the case of bond funds, this is no different, there are many risks in every bond fund that may arise once in 200 years, but still exist from it. Let’s look at these all the way through.
A feature of an open-ended mutual fund is that the units can be redeemed at any time. There is no time or quantity limitation on redemption. This requires adequate liquidity. It is unlikely, but there may also be such an extreme case, that due to large redemptions, investors withdraw so much money from the bond fund that it is necessary to sell the underlying investments under duress, even at a price. This forced sale is also detrimental to investors.
The fund manager carries out its activities in accordance with the legal regulations and supervisory recommendations applicable to fund managers. It selects its employees with the utmost care, however, either due to external influences or internal personnel problems, the operation of the bond fund and thus the fund’s performance may be affected.
Foreign exchange risk
The assets in the bond fund and the interest received on them may be those that are not determined in domestic currency, but in a foreign currency. They are then calculated at the current daily exchange rate when determining the asset value. Although the fund manager managing the bond fund makes every effort to mitigate foreign exchange risk through various means, this cannot be fully hedged. The results of the part exposed to foreign exchange risk are affected by the development of foreign exchange rates, which may also affect the asset value of the bond fund and thus the exchange rate.
The risk arising from the unknown value of an asset per unit
It has a nice long name, but its content is simpler. When you place an order to buy or redeem a unit of a bond fund, you only know the exchange rate known at that moment. However, this is not the same as the exchange rate at the time the order is executed. With this, you can do well and you can go bad.
Credit and counterparty risk
Most of the money in bond funds is in bank deposits on the one hand and in debt securities on the other. Bond funds invest money in either hundreds or even thousands of directions. In order for the fund manager to say yes in any direction, he/she must first be convinced of the stability of the prospective partner. Despite all this, despite the most careful selection, future bankruptcy cannot be ruled out with complete certainty.
In extreme cases, the possible bankruptcy and insolvency of the financial institutions managing the deposit or the issuers of securities may lead to a significant decrease in the value of the assets in the bond fund, or even their complete cessation. This can have a significant effect on changes in the price of investment certificates.
Risk arising from the political, economic and regulatory environment
Political decisions can have a significant impact on economic life, and the money and capital markets are no exception. If conditions change, the return on investment changes, which affects the exchange rate through the calculation of the net asset value.
Such factors are, for example, inflation, interest rate and exchange rate policies, or even changes in the legal environment.
Risk due to changes in interest rates
As the portfolio of bond funds consists predominantly of debt securities (i.e. bonds) and bank deposits, the interest rates available to anyone have an impact on the price of the fund. As discussed earlier, if investors can achieve higher interest rates through, say, government securities, the price of the bond fund will fall, and vice versa.
The fund manager strives to determine the price of the bond fund as accurately as possible, while complying with legal regulations. Nevertheless, the valuation of securities with a lower turnover may be difficult if, in the absence of turnover, the public price is older. While this may cause a minor divergence for a bond fund with a well-diversified portfolio, they may nevertheless be temporarily undervalued or overvalued.
- Have you ever used a bond fund for investment purposes?
- What characteristics (geographical exposure, currency, etc.) would you consider important if you choose a bond fund?
- How long would you plan with the bond fund?
I look forward to your comments on your questions. If you would like the help of our experts on this topic, you can contact us here.