There are many misconceptions around regarding the difference between a bond and a bond fund. This article will serve to outline the key differences between both instruments, and what to look out for when investing in each security.
By definition, a bond is a debt obligation issued by entities, such as companies or governments. When an investor purchases an individual bond, s/he is essentially lending his/her money to the issuer of the bond for a pre-defined period of time.
In exchange for this, the bond issuer will pay the investor/bondholder interest till the maturity/expiration of the bond. On this date, the bond issuer will also reimburse the investor with the original investment or loan amount (known as the bond principal).
Bond funds are mutual funds (collective investment schemes) that invest directly in bonds, as the manager of such funds pool investor’s monies into one pot. In simple term, 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 which the bond fund manager can invest in will depend on the objective of the said bond fund. So for example, a Malta Government bond fund will be primarily composed 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 governed 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 by such guidelines by law.
In the case of individual bonds, the traditional investor 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 of the bond will be 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 does not honour its financial obligations and default on the payment of the principal.
The same cannot be said for mutual funds (or collective schemes in general), and this applies to all funds and not simply bond funds. With a bonds fund, the investor has 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.
What is important to grasp however, is 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.
Therefore, if bond prices are falling, the bond fund could be exposed and lose some of their 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 bond holder 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 technicality of things, there are several pros and cons of investing in direct bonds vs in a bond fund. Investors opting to invest in direct bonds have the onus of monitoring the creditworthiness of the underlying bond issuer and assess from time-to-time whether the bond issuers financial profile is improving or deteriorating, quite an arduous without the necessary skills set.
Investment managers are equipped with the right tools to be able to adequately scrutinise company (issuer) balance sheets, devise interest rate forecasts, and identify any mispricing in the bond market. All these serve to help fund managers position and align the assets within a fund (duration and allocation) with his/her 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, views and opinions provided in this article are 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. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.
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