Simple Pound

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A bond fund works very similar to a share fund (i.e. mutual funds), in that someone else will buy and manage bonds for you. This means you won’t have to worry about inflation, interest rates, credit ratings of firms, etc. because the fund manager is there to take that responsibility from you. Obviously to be able to lean back and enjoy all the benefits, you will have to do some initial research on the different funds available in order to make sure your chosen fund manager shares your investment objective, and obviously does so well. Bear in mind that past performance is at best an indicator of quality - not a guarantee!

So why should you rather buy a bond fund as opposed to just simple buying the individual bonds yourself? There are a variety of advantages, some of which include:

• Diversification: Bond funds usually cover a number of different bonds, with different coupon rates and maturity dates so the performance of one bond (i.e. should the issuer not be able to pay the coupon rate or (upon maturity) the par value) does not impact the overall performance too heavily. Moreover, you’ll often find bond funds that are also diversified across different bond types, i.e. funds that cover both government and corporate bonds. Therefore you can achieve a great deal of diversification with only a fraction of the investment you’d have to sacrifice in order to re-build this diversity yourself.
• Professional management: I went on and on about how mutual fund managers earn their living by picking shares for you and spend hours and hours researching each and every company represented in their fund. Bond funds and their professional managers are no exception to this, which also means that you will have to pay some fees in order to support your fund manager’s salary. So make sure you pick a good one, to justify the extra expense.
• Liquidity: The great thing about investing in bond funds is that you are not tied down by a maturity date. If you want your money tomorrow, you can sell your fund shares and get your cash out at any time. Your shares will either be bought by someone else wishing to invest in this particular bond fund, or will simply by the company that is managing the fund.
• Regular income stream: Buzzword passive income. Passive income is income generated without requiring any action from you. In the case of bond funds this will be your fraction of the coupon rate that is paid monthly. But since the bond fund covers a number of bonds which all potentially pay out on different days of the month, you might generate income every single day of the week (even though it might still only be paid out monthly). If you don’t want the additional monthly income (because you’d spent it anyway…), you will have the option of automatically re-investing those payments. Therefore the amount you’ve originally invested will grow steadily - thus earning you bigger portions of the coupon rates, which in turn will give you higher income… The power of compounding at its finest!

To analyse the performance of a bond fund, you should look at three important values: its share price, its yield and its total return.

The bond’s share price represents the bond’s net asset value, which is based on the value of all securities in the bond - i.e. the share price reflects how well the bonds are rated and whether most of them are priced above or below their par value.

The yield tells you how much additional monthly income you would have had in the past 30 days if you’d have owned shares in the fund.

And finally, the total return is almost a mixture of the above values in that it shows the fund’s overall gain (or losses) based on the income generated and the price gains (or losses) of the bonds in the portfolio. Fidelity suggests you should concentrate on the last value when making decisions about which bond funds to invest in.

Alright, I hope this wasn’t too dense. I just sat my Finance exam this morning, so all this jargon sounds fairly familiar to me - admittedly only after six weeks of solid revision. As always, let me know whether you have any questions by leaving a comment and I will do my best to find an answer…

Read part 8 of “Investment Choices” on unit trusts >>

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