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Why income in bond funds cannot be fixed

Why income in bond funds cannot be fixed - (A)

Be it a scorching sun or pouring rain, a tall sprawling tree would definitely offer some protection. It’s human nature to seek refuge when things get too extreme for your liking. I would also look to stock markets for protection if markets become too volatile or return become uncertain in the short term. In general, bond funds are considered the tree under which investors can protect themselves from market volatility. As an investor, you probably want growth in your portfolio, and to achieve this, you will inevitably invest in stocks. If you are an experienced investor, you will also understand the importance of downside protection for your investment portfolio, and therefore you will most likely choose to invest in fixed-income funds which can provide some stability as well as a “low-income”. pin” to your wallet. . But the key question here is whether all fixed-income funds offer “fixed income investing.” The short answer to this question is “no”. Now comes the long answer.

Fixed Income Securities Risk

It is well known that the price of a bond is inversely proportional to the interest rates prevailing in the economy. So when interest rates in the economy start to rise, bond prices will go down, and when they start to go down, bond prices will go up. This change in the price of the bond results in capital gains or losses. This is the first source of returns. The second source of return is, of course, the bond’s interest rate based on the bond’s coupon rate. At a minimum, this tells us that fixed-income securities are not completely risk-free. Some of the risks you should know about:

Interest Rate Risk: This is nothing more than the reaction of a bond’s price to changes in interest rates. If prevailing interest rates fall, the price of your bond will rise and vice versa. The economic environment and market conditions are the main factors that affect interest rates in the market. Also, the longer a bond’s maturity, the greater the impact of a change in interest rates on its price.

Inflation Risk: Inflation plays a key role in determining interest payments for bond investors. As you know, bonuses offer a fixed amount of income at regular intervals. However, if inflation rises, your bond yield may not match the rise in inflation. This means that you risk losing purchasing power.

Credit Risk – This is another risk factor that tells us that returns on fixed-income securities are not necessarily fixed. When you invest in fixed-income securities, you are expected to receive timely interest payments and a repayment of your principal when due. However, sometimes bond issuers cannot meet their payment obligations and default. For example, in 2017-2018, several companies in the steel and electricity sector failed to comply with their obligations. The issuer’s risk of default is called credit risk. In general, this risk increases with companies that are not very well-rated by rating agencies.

Liquidity risk: This is when you want to sell your fixed-income security but can’t find a buyer because they are willing to sell the bond before maturity. Liquidity risk is generally higher for bonds with lower credit ratings.
Duration risk: We already know that the price of a bond is inversely proportional to changes in interest rates. However, not all bond portfolios react the same way to a specific change in interest rates. Duration risk measures the specific impact of interest rate changes on a given bond portfolio and can have a significant impact on your bond yields. If you know the duration of a bond, you can assess the change in a bond’s price given the change in interest rates.

Make the right decisions to reduce risk and improve returns

It is well known that India has one of the highest road fatality rates in the world. Does this mean you stop driving your car or taking trucking? No! Instead, learn to manage risk. While there are risks with investing in fixed income (just like any other investment), these can be easily managed. What you really need to consider is the modified duration of a bond portfolio and then make an investment decision accordingly. Modified duration basically tells you how a bond’s price will react to a given change in interest rates.

Suppose the mutual fund portfolio you want to invest in has a modified duration of five years and the interest rate changes by 1.5%. Due to the change in interest rates, the price of the bond portfolio is affected by 7.5% (1.5 x 5). In general, bonds with longer maturities have a higher modified duration and are therefore subject to greater volatility due to changes in interest rates. Therefore, the amount of time you invest and your ability to absorb volatility are directly related to the modified duration.

There are two ways to manage this risk.

• Adapt your investment horizon to the modified duration of the fund: very simple. All you have to do is look at the fund’s modified duration on the information sheet and make sure it fits your investment horizon. For example, if you have a 2-year investment horizon, invest in funds that have a modified duration of fewer than 2 years.

Invest in funds with a target maturity – Some funds have a maturity of a certain number of years, e.g. B. 3 years, 5 years, or 10 years. To meet that target maturity, they invest in bonds of the same maturity and simply hold them until maturity. Since the bonds in the portfolio are held to maturity, interest rate risk is greatly mitigated. If you choose to remain invested in a target-maturity debt fund until maturity, you can expect returns similar to those you had when you invested in the fund (yield at the time of investment). Even if it were periodic price fluctuations, you get the expected returns at expiration. This reduces the impact of interest rates on the value of your investment.

Fixed-income securities can actually become that umbrella, protecting your portfolio from rain and sun. However, you must be aware of the risks and make the right investment decisions accordingly.


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