It is safe to state as a fact that there are many misconceptions regarding the intricate differences between a bond and a bond fund. In this article, I will attempt to outline the key differences between both instruments, and what to look out for when investing in each security.
A bond is a debt obligation issued in the form of a financial instrument by entities, such as companies or governments. When an investor purchases an individual bond, s/he is lending his/her money to the bond issuer for a fixed time period.
In exchange for this, the bond issuer will pay the investor/bondholder coupon interest till the maturity/expiration of the bond. In addition to this, the bond issuer will also reimburse the investor with the original investment or loan amount, what is better known as the bond principal.
Bond funds, in the legal form of collective investment schemes, invest directly in individual bonds, as the fund manager of such funds pool investor’s monies into one pot. Put simply, a bond fund can be viewed as a basket of a number of bonds (lots of them, varying from 20 to over a hundred) within one bond portfolio.
The types of bonds will depend on the objective of the bond fund. For example, a Malta Government bond fund will made be up of Malta Government Stocks whilst an International Bond Fund could have an array of government and corporate bonds, investment grade and high yield bonds, of varying maturities.
In the case of bond funds, Investment Managers are guided by a pre-determined set of investment rules, guidelines and parameters within which the underlying investments must conform to, as the manager is duty bound to abide to such guidelines by law.
Traditionally, investors who hold individual bonds will hold the assets until maturity and throughout the life of the bond will receive interest, usually on an annual or semi-annual basis.
The price is naturally subject to market forces and hence fluctuate while being held by the investor. However, the investor can receive 100% of his or her initial investment on maturity. This means that there is no loss of principal, if the investor holds the bond till maturity, assuming that the issuer of the bond honours its financial obligations and does not default on the payment of the principal.
This point is crucial to highlight as the same cannot be said for collective schemes. With a bond fund, the investor owns a share (in the form of units) of the interest being generated (and subsequently paid out) by the underlying bonds held within that bond fund.
It is imperative to note the concept that funds are not valued by a price but what is known as a net asset value (NAV) of the underlying holdings in the portfolio.
If bond prices are falling, the bond fund could be exposed and lose some of its principal investment (as the NAV of the fund can decline), but on the flipside can benefit from an increase in the price of bonds in a declining yield scenario.
If a bondholder hold his/her investment till maturity, the individual bond investor will not receive more than the principal investment (unless they sell their bond before maturity at a higher price than they purchased it).
Without going into the nitty gritty, there are a number of pros and cons of investing in direct bonds in comparison to investing in a bond fund. Investors choosing to invest in direct bonds have the responsibility of monitoring the credit worthiness of the underlying bond issuer and assess from time-to-time whether the bond issuers financial profile is improving or deteriorating.
This can be quite arduous without the necessary skills set. Investment managers are equipped with the right tools and skills set to be able to accurately analyse bond issuer’s balance sheets, devise interest rate forecasts, and identify any possible mis-pricings in the bond market.
All these serve to help fund managers position and align the assets within a fund with their strategy and market outlook, something which an individual investor might not be in a position to achieve without the proper guidance.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.