5 Things to Know Before Investing in Fixed Income Funds
By Nipapun Poonsateansup CFP®, Independent financial planner, writer, and lecturer
Fixed income funds are mutual funds that focus on investing in debt securities, in which debt securities will show creditors to holders of a document. Example of debt securities includes government bonds and debentures. If the debt securities are issued by the government, we will call it government bonds. On the other hand, if issued by the private sector, we will call it a debenture.
The fixed income fund is considered an important tool for investors who want to rest or need a moderate risk and have an investment period of 1-2 years or more. In addition, the mutual fund is also important for investors who have a portfolio of Asset Allocation investments because it can help reduce the risk of investment portfolios and can also be used as liquidity in situations that require cash to adjust the port because it is a high liquidity fund. If sold, the investor will receive money on T+2 (the 2nd business day from the date of purchase-sale of securities, not including Saturday and Sunday and holidays of financial institutions as announced by the Bank of Thailand). This article, therefore, presents what investors should know before investing in fixed income funds as follows.
1. Can the mutual fund be a loss?
We believed that many investors would have such doubts as well. If investing in fixed income funds, will there be a chance of loss? Since what we get from investing in fixed income fund is a fixed interest, for example, 3% per year and paid every 6 months, it looks like a consistent return. And how can we lose?
The reason that the mutual fund is a loss is that when we (or the fund manager) has already invested in one debt securities, it means that we loss the opportunity to bring this money to find other investments that may give higher returns. Suppose that the fund invests in long-term fixed income fund, such as investing in government bonds that receive 3% interest per year for 5 years. The fund invests in a 5-year government bond means that we will be locked at a 3% return rate for 5 years. If time passed and the interest rate in the market is higher, the fund will lose the opportunity to invest money in higher yield assets, such as new government bonds that may yield higher than 3%.
Therefore, if the fund wants to invest money in a new government bonds and want to sell investment in the old government bonds, the fund will have to sell bonds held on hand at a discounted price. For example, if assuming a newly issued government bond, gives interest at 4% with interest difference at 1%, thus, investors in the market will buy government bonds from the fund (trading in the secondary market) only when there is a discount price that is equal to 1% of the difference in interest. Otherwise, investors will go to buy new government bonds that give better returns. Therefore, this is the reason that if interest is likely to rise, long-term debt securities will have a lower price (because they have to be discounted). When the price of debt securities in the portfolio decreases, it affects the NAV (Net Asset Value) of the mutual fund (NAV is negative) because the mutual fund must calculate the net asset value by using the market price or “Mark to Market” at the end of each working day according to the rules of the SEC.
2. Where are the returns from the mutual fund?
What investors can get from investing, whether investing in private corporate bonds or government bonds, is the interest received as specified (coupon) and profit from the capital gain, if sold at a price higher than the purchase price. Whereas if sold at a lower price than the purchase price, it will lose in this part, which has already been explained in no.1 the reason we have a chance to lose from investing in fixed income funds.
3. What is the credit rating? How important is it?
Credit Rating is an evaluation of the creditworthiness of the debt securities by "Credit Rating Agencies" that has been approved by the Securities and Exchange Commission (SEC). There are 2 locations in Thailand: TRIS Rating Co., Ltd. and Fitch Ratings (Thailand) Co., Ltd.
The level of credit rating is a tool that measure the risk of default of debt securities. With the higher credit rating of the debt securities, the risk of defaulting is even lower (and of course, the return will be less than the debt securities with a lower credit rating). The credit rating is divided into two groups: Investment Grade or Investment Group (AAA to BBB-) and Speculative Grade or Speculative Group (BB + - Down to D). Therefore, if investing in Fixed Income Funds, you must not forget to consider the credit rating of the debt securities that the fund has invested in.
4. What is the benchmark of fixed income fund?
Government Bond Index is the main index to measure the movement of debt securities market, in order to compare the return rate with other assets and used as a benchmark to measure the performance of the debt securities.
In addition, we can use the government bond index as a tool to reflect the market interest rate. That is, if the interest rate has decreased, the price of debt securities will rise, resulting in an increase in the index. On the other hand, if the market interest rate has increased, the price of debt securities will decline, resulting in the index falling.
5. Who is the investment in fixed income funds suitable for?
Investing in fixed income funds is suitable for investors who do not want much risk and do not expect high returns. Debt securities that are invested in each type of fixed income fund, will have different risks such as if investing in government debt securities, they will have a very low risk and there will be additional risks if invest in private corporate bonds, but is still considered a mutual fund with low risk.
In addition, fixed income funds are also suitable for those who miss the opportunity to buy government bond or bonds of private companies that tend to compete for subscription during the offering period. Nevertheless, you must not forget to study the information of mutual funds that we are interested in investing by reading and understanding the prospectus before investing.