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By Investopedia definition: “A fund invested primarily in bonds and other debt instruments. The exact type of debt the fund invests in will depend on its focus, but investments may include government, corporate, municipal and convertible bonds, along with other debt securities like mortgage-backed securities.”
People usually think of bonds as safe investments but there are dangers to it that are not so obvious to investors. One such danger is having a bond fund in a low interest rate environment like how it is in Thailand now. As the interest rates increases, the bond fund market value drops causing the investor to lose the principal if there is a need to sell the bond. To avoid this risk, it is recommended to buy shorter maturity bonds and hold them until they mature.
In order to determine how sensitive a bond portfolio is to interest rate increases, a standard measurement is used. Duration or the measurement standard means the approximate drop in value for a 1% increase in interest rates. This is now referred to as the average maturity and both the duration and the average maturity are good ways to compare bond funds in the prevailing economic environment in Thailand. Most bond funds should have these two on their fact sheets as a way for investors to know if their bond fund is a good investment or not.
To understand the fund’s duration, investors should look solely at the recent track records of two funds for comparison. If one fund has averaged 10% with duration of 2.5 and another fund has averaged 12% but with duration of 8, between the two funds, investors should choose the first fund as it offers a much better trade-off between the risk and the reward. If the interest rates go up by 2%, the second fund will lose approximately 16% compared to the 5% loss incurred by the first fund.
Duration is also only an approximation because it is based on the assumption that the yield curve shift is parallel, which does not always happen. In simpler terms, it means that a 3-year bond interest rates are not likely to change by the same amount as they will for a 10-year bond or a 20-year bond. The error is likely to be larger if lower interest rates are at the start and the greater the overall move in interest rates.
Most bond funds with large portions of debt from safe governments in the developed world will usually fall into one of two categories right now. They either don’t make any money or they have a lengthy duration. This bond fund is therefore very risky especially when the interest rates return to normal levels in due time.
Bond funds with decent yields and lower duration can be found in some globally diversified lightweight bond funds in the developed world. Such bond funds can earn a little money because the interest rates in other countries do not have solid bottom. The drawback in this case is that the fund faces exchange risk relative to each of the bonds it is holding.
Recommended funds that apparently produce good yields are the Global Total Return Fund and the Global Bond Fund both run by Franklin Templeton. While they don’t guarantee yearly yields, historically, these two funds tend to do very well in good times and not so bad in rough times.
Taking these two bond funds in a way provides some kind of portfolio diversification as most developed world bond funds should be avoided unless they are extremely short weighted maturity funds with low duration.
To fully understand how bond trading works, there are people who have been avidly watching the interest rates and maturation of bonds. These people can help anyone who is interested to invest in bonds and make them understand how it really works. Managing and investing those hard earned money is difficult especially if the investor do not have a full knowledge on the field of his/her planned investment. Getting financial advisory in the island of Phuket would be of big help in putting light to a bit clouded or jarred bond trading information.
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