Bond mutual funds are enjoying continued popularity in Canada, with the latest figures reporting net sales of over $16 billion in 2019. By comparison, Canadian investors actually withdrew $11.4 billion from their equity funds.
This investment universe, while considered less “risky,” still involves some operational rules that it could be important to know, especially when substantial investments are involved.
Here’s an overview built around 3 basic concepts.
1. The debt market
Stocks are equity securities that allow investors to profit from a company’s growth (if any). Bonds are debt securities: they are issued by companies or governments to finance operations. In return for their investments, investors receive regular interest payments and are guaranteed to recover their principal at maturity, subject, of course, to the issuer’s financial solvency.
In bond jargon, each interest payment is called a “coupon.” For example, a $100,000 bond maturing in 10 years and bearing interest at 1.50% paid annually will have 10 coupons worth $1,500 each.
However, unlike other interest-bearing investments, such as guaranteed investment certificates, bonds and coupons can be traded on the secondary market. Thus, when you invest in a bond fund you are entrusting your assets to a manager who will actively manage the fund and who can buy and sell securities before they mature.
And that’s when the market rules come into play.
2. Market value and current yield
Since there’s a market, there will inevitably be price fluctuations. This means that the market value and the current yield of a given security can rise or fall.
In the example given above, an investor who holds the bond until maturity will receive all of the interest payments and will recover the full $100,000 principal. But if, for one reason or another, the investor sells the bond earlier, he or she will receive a price that depends on the market, and that will affect the current yield.
In mathematical terms, the following formula explains how a bond price is calculated.
3. A significant variable: interest rates
If your math skills are a little rusty, just pay attention to the variable “i,” which designates the prevailing interest rate. The fact that it’s in the denominator suggests that an increase will make the bond’s market value drop while a decrease will make it rise.
Actually, there are many factors that can influence the value of a bond, including the stock market outlook (which can provoke a “flight to safety”), inflation, impairment of the issuer’s creditworthiness, etc. But one of the most significant would be interest rates, or even the anticipation of a rate increase or decrease.
As shown by the following illustration, when interest rates are rising, bonds bearing a lower rate become less attractive on the market and their value falls. On the other hand, when rates drop, fund managers can sometimes make substantial gains as the bonds in their portfolios appreciate in value.
In this dynamic of supply and demand, another factor will generally play an important role: the duration of the bond, i.e. the number of years to maturity. The following simulation shows that, under normal market conditions, a rise or fall in interest rates will generally affect a short-term bond less than a long-term bond.
With that in mind, it could be important to pay attention to the average duration of any bond fund you might invest in: a shorter duration may often reflect a more “conservative” attitude on the part of the manager.
Clearly, the bond market can be a complex and at times volatile environment. As well, since it has a larger volume than the stock market, its fluctuations may sometimes have unanticipated effects.
If you invest in bond funds, you should not hesitate to talk to your mutual fund representative* to gain a better understanding of the finer points of this market.
The following sources were used to prepare this article:
Fidelity Investments, “Bond prices, rates, and yields.”
FreeOnlineCalculatorUse, “Bond Value Calculator.”
GraduateTutor.com, “An Introduction to Bonds, Bond Valuation & Bond Pricing.”
IFIC, “IFIC Monthly Investment Fund Statistics – October 2019.”
Learning Markets, “What Are Bonds and How Do They Work?.”
Securities and Exchange Commission, “Interest rate risk — When Interest rates Go up, Prices of Fixed-rate Bonds Fall.”