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‘Capital guaranteed’ - I don’t think so

What is the difference between a bond and a bond fund? I was asked this question yesterday and it is important investors know the difference between the two prior to building their own portfolios.

A bond is a loan a company/government or entity engages in with the public or third party in return for a pre-determined rate of interest throughout the loan duration.

Hence, were I to borrow €100 from my friend Jerry today for five years, I would pay Jerry an amount of interest on his €100 loan per year or semi-annually as compensation for the risk he undertakes in lending me the money. Once the five years are up, I would then be due to return Jerry’s €100 original loan along with his final interest payment on the loan.

It seems simple in context, but bonds are far more complex than they seem. Prices tend to fluctuate throughout the duration of a bond and repayment of a bond’s principal depends on a number of factors, notably a company’s cash flow condition (or country’s balance of payments), bond seniority in the capital structure, industry and macroeconomic environmental conditions and the basic economic concepts of demand and supply.

A term popularly used in Malta is the phrase ‘capital guaranteed’. There is no such thing! If you want to invest money, a proportion of risk is required. Based on your risk tolerance and capability, the assistance of an investment advisor can then guide you accordingly towards investment grade or high yield bond investments. Both, nonetheless contain differing elements of risk.

The Lehman default of 2008 was a clear shock to the ‘capital guaranteed’ mentality Maltese investors had by investing in high rated bonds. Although Lehman had an A rating, the result proved that big renowned banks are also capable of defaulting on loan obligations.

Individual bonds are therefore riskier to hold in terms of default risk than bond funds would otherwise be, regardless if they’re corporate or sovereign issues.

A bond fund can be seen as a basket of many individual bonds, which abide by the fund’s initial strategy and objectives. Here, investors are no longer exposed to the direct default risk on the underlying bond positions and are instead exposed to the fund (usually set up as a corporate entity), whose management is delegated to fund managers.

The benefits of bond funds allow investors to benefit off the interest income on the underlying bond holdings whilst free from any default risk on the underlying issues. Default risks are borne by the fund instead, and the large number of individual bond holdings mitigate the huge impact a default would otherwise have on an individual investor, via the benefits of diversification.

The more diversified a fund is (ie. the more uncorrelated investment holdings are to each other) the lower a default’s impact will have on total fund performance. A fund can continuously diversify holdings until the only remaining risk to the fund’s positions is market risk, which cannot be controlled by fund managers and asset allocation decisions.

Whilst investors may frown on the number of fees imposed by funds in the form of entry and management fees, the benefits of diversification, consistent income and/or capital gains, outweigh the costs levied and may be the better option for the risk averse, ‘capital guaranteed’ perceiving  investor wanting to bear ‘no’ risk whilst making some  cash.

Disclaimer: This article was issued by Mathieu Ganado, Junior 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 & Co. 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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