When I meet with both prospective and existing clients and I ask the question: “What are your investment goals?” the two most common responses are that they are seeking to grow their funds for retirement or saving for their children’s college education.

Frustration with savings accounts and other traditional fixed rate deposits have led them to explore investment options. But even then, they are often disappointed as they are faced with the reality of low returns on fixed rate investments. Gone are the days of double-digit interest rates — which is not great if you are borrowing funds, but great when you are saving or investing.

Bonds are good long-term investment options, and of course we have said over and over again that diversification is key for investing success, so it is best to create a portfolio of bonds as opposed to investing in just one or two bonds.

But what if you don’t have sufficient means to construct a portfolio with adequate diversification? Where do you turn? The answer to your dilemma could be a mutual fund.

When most investors mention mutual funds, they are usually talking about funds that invest in stocks. Bond funds work just like stock funds, but they invest in — you guessed it — bonds rather than stocks.

A bond mutual fund, or ‘bond fund’ as it is more commonly called, is a professionally-managed fund that is invested primarily in bonds and other debt instruments. The type of debt the fund invests in will depend on its focus, but investments may include government, corporate, municipal and convertible bonds, along with other debt securities.

Benefits of bond funds

Since bond funds own a number of individual bonds, the impact of any single bond’s poor performance is lessened. Ordinarily, it would be challenging for most investors (especially smaller investors) to put together a diversified bond portfolio because bonds are sold in much larger denominations than stocks.

The investment minimums for most bond funds are low enough that you can get significantly more diversification for much less money than if you purchased individual bonds. Look for bond funds that are diversified across maturities and bond sectors to get the maximum benefit.

Bond funds offer higher returns than bank accounts, certificates of deposits and money market funds. The performance of a bond fund is determined by the performance of its underlying investments. Every bond fund has a net asset value (NAV), or share price, which is the dollar value of one share of the fund.

The NAV is based on the value of all the securities in the portfolio. If the NAV goes up, the value of your investment goes up, if the NAV goes down then the value of your investment goes down. Look for a bond fund that has a long, positive track record; but bear in mind that past performance is not a guarantee of future performance.

A bond fund has professional portfolio managers and analysts who have the expertise and technology to research the creditworthiness of bond issuers and analyse market information before making investment decisions. So, as an investor in the fund, you get to share in the glory without all the work.

Risks of bond funds

The major risk of a bond fund is that the future returns are not known and are not guaranteed. When you sell shares in a fund, you receive the fund’s current NAV, which is the value of all the fund’s holdings divided by the number of fund shares. If the fund’s NAV is lower on the day you sell shares than it was when you purchased them, you could lose some or all of your initial investment.

The other risks associated with bond funds are the risks inherent in the bonds that the fund is invested in. For example, credit risk, interest rate risk, etc.

If interest rates rise, bond prices usually decline, and if interest rates decline, bond prices usually rise. The longer a bond’s maturity, the greater the bond’s interest rate risk and so a bond fund with a longer average maturity will likely see its NAV react more dramatically to changes in interest rates. A good fund manager will mitigate the impact of rising interest rates by shortening the duration of their portfolio.

It is important to know the credit quality of the bonds that are held in the bond fund in which you are investing. Most bonds are rated by third party rating agencies, such as Standard & Poor’s or Moody’s, to help describe the creditworthiness of the issuer. Credit risk is a greater concern if the fund invests in lower-quality bonds. The fund’s prospectus will describe its credit quality policies.

As I mentioned before, the good thing is that these risks are mitigated because a bond fund is made up of many individual bonds. By owning a large number of bonds, the impact of any one bond defaulting or being called away prior to maturity (forcing the fund to reinvest the proceeds at a lower, prevailing rate of interest), is lessened and the potential returns are higher.

So are you saving for a long-term goal such as retirement or your children’s education, but don’t have a large sum of funds to create a diversified fixed-income portfolio? A bond fund makes perfect sense, don’t you think?

— Toni-Ann Neita is assistant vice-president, personal financial planning at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments in US and other world market currencies to the corporate, individual and institutional investor.

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