What to look for in a Bond Fund
Performance of the fund is clearly the driving factor for all investors, but it is only one factor in assessing fund choice for an investor, and must be judged against the risks that the fund manager takes in delivering these returns.
Such risks are to do with: the credit ratings of the investments in the portfolio - Credit Risk, the Liquidity Risk of the portfolio with regard to the ease of sale or purchase of the portfolio investments without impacting price, the Price Risk which can be judged against the maturity profile of the investments and the mix of investments in terms of sectoral allocation and finally Volatility, which is a measure of the consistency of NAV movement in the short and the longer term. Let's look at these in some more detail.
Performance is a quantitative tool, measuring NAV movements across periods of time, and is easily derivable. This is therefore a measure that most advisers latch onto in terms of recommending funds to investors. Typically performance should be looked at over 3 months, 6 months, 1 year, 3 years and longer duration to determine the consistency of returns and therefore the ability of the fund manager to replicate performance in the future. Performance should be compared on a rolling basis. For funds in existence for less than a year, returns must be compared on an absolute basis. For funds in existence for greater than a year, compounded annualised return should be used.
Lower the credit, higher the return - but beware: Understanding credit quality is one of the two core tenets of measuring risk of a bond fund portfolio, the other being price risk which will be discussed later. Government securities are regarded as risk free, and form the basis of corporate finance theory in terms of establishing risk-return benchmarks. Securities that are AAA rated, will typically trade at a small spread above government securities, for these are regarded only next to government securities in terms of the safety of the capital and interest cash flows. However, a security rated A will trade much higher. But as the ratings move down the risk of default on interest and even capital become more real, particularly when the economy cycles back into periodic slowdown. We are sure you wouldn't chase higher returns at the risk of losing capital?
Liquidity flows from credit quality, and is very important: Higher credit quality of the portfolio is correlated to liquidity of the fund. Why is liquidity so important? For any investor, the ease of transacting, both at the time of investing and redeeming, is key. If the NAV price moves either for buying or selling then the return to the investor will suffer. For a bond fund manager, who sees significant fund flows with investors coming in and out of the fund, the ability to buy or sell portfolio securities at a fair and transparent price is fundamental to maintaining consistency and sustainability of NAV price performance and safeguarding investor interest.
Maturity profile of the portfolio will determine price risk: Interest rates move up and down all the time, determined by macroeconomic influences as well as structural and technical funds flow reasons. This movement of interest rates has significant impact on the pricing of bonds depending on the maturity of the bond. If a bond is due to be redeemed in the short term - say less than a year, the impact of a rise or fall in interest rates will be much lower than on a bond with 10 years tenure. Similarly a portfolio consisting of bonds with a low average maturity profile will have low impact on price movement in the NAV price as a result of volatile interest rates as compared to a fund with higher average maturity. In order to maximise gains to the fund, the portfolio should take into account possible interest rate movement in the future, although it is difficult to predict interest rate movement. So in a volatile environment, a portfolio is well positioned if it is at the short end of the market The price risk arises from the ability of the fund manager to forecast future interest rate movements.
Volatility of NAV prices is also regarded as a factor that influences the investor in his choice of funds. We believe that volatility is important in a relative sense against a benchmark, or peer group funds, in the absence of an appropriate benchmark. However, we are also of the view that short term volatility arising out of anomalies in pricing and valuation methodologies adopted by funds, are unimportant in relation to longer term volatility say over 6 months and preferably on a 12 month basis. Investors in bond funds typically don't come for the short term. So the volatility match must be looked at in the context of the investors time horizon, which would typically be 6 months and above.
Valuation & Transparency
In the long run the performance return to trend due to shorter term valuation anomalies, in the absence of industry guidelines and uniformity, there are shorter term aberrations as different funds follow differing valuation methodologies. SEBI has recently issued guidelines on valuation norms and practices across the industry, which is good news for investors.
The size of the fund is also very important. Larger funds have the ability to be more diversified in their investments thereby reducing market risk somewhat. In addition larger funds will also have the first pick of the cherry in terms of investment issues and in the market. For larger investors particularly, size of the fund will offer liquidity, diversification and the probability of higher returns.