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Fixed Income Funds

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From Ranga Chand's Getting Started with Mutual Funds

The aim of any income fund, not surprisingly, is to provide investors with regular income payments while protecting capital. Of course, this type of fund is useful not only to people seeking additional income. Income funds are also a good choice for adding diversification to any investment portfolio. They invest mainly in, or in some combination of, bonds, debentures, and mortgages.

What Is a Bond?

A bond is a certificate of indebtedness recording the amount of the loan and the terms of repayment. The main difference between a bond and a debenture is that while a bond is secured by assets of the issuer, such as equipment or real estate (much like your mortgage is secured by your home), a debenture is backed only by the issuer's general creditworthiness. In other words, the issuer does not put up any specific assets to assure repayment of the loan.

Bonds are bought in either the primary or secondary markets. After a bond has been issued and sold to investors in the primary market, it can then be traded in the secondary market. The price you pay or receive will depend on current interest rates and other factors. Do not confuse these bonds with the familiar Canada Savings Bonds, which are not traded and are cashable at full face value plus any accrued interest at any bank at any time.

Bond jargon is like talking in another language. You don't have to be fluent, however -- you only have to know the basics. Once you know the following key terms, you'll sound like a bond trader. More importantly, when it comes to buying a bond fund, you'll feel much better when you understand what the salesperson is saying.

Issuer. The body, such as a federal, provincial, or municipal government, public utility like Ontario Hydro, or corporation, that issues the bond. These government bodies and corporations need to borrow money to pay for such things as expansion of facilities, machinery, long-term capital work projects, or repayment of existing debt. In this way, they are not much different from the rest of us -- except they need to borrow a lot more.

Issue date. The date on which the bond is issued and interest starts to accrue.

Term. The life span of the bond from the issue date to the maturity date. Short-term bonds mature in one to three years, medium-term bonds in three to ten years, and long-term bonds in anything over ten years.

Face value, par value, or denomination. The value that appears on the face of the bond certificate and is paid at maturity. If you purchase a $5,000 bond and pay the full face value, you have bought "at par." If, however, you pay $4,900 for that bond, you have bought "at a discount" (less than the face value), and if you pay $5,100, you have bought "at a premium" (more than the face value).

Maturity date. The date when the amount borrowed by the bond issuer must be paid back and interest payments stop.

Coupon. The fixed annual interest rate paid on a bond. Some bonds have coupons attached which you cut off on the due date and send in to receive your interest payment. Hence "coupon rate" instead of the more familiar "interest rate." If you buy a $10,000 bond at par maturing in five years with a 12% coupon rate, you will receive $1,200 in interest every year, regardless of whether current interest rates are higher or lower, until maturity.

Market value. The price you receive, for example, if you sell your bond before the maturity date. This could be higher or lower than the price you originally paid, depending on numerous factors such as current interest rates, the length to maturity of your bond, the financial health of the issuer, political uncertainties, and market rumours.

Yield. This describes the amount you actually earn from a bond; and is calculated by dividing the amount of money a bond will pay in interest by the price of the bond. Suppose you purchase a $5,000 bond at par (you pay the full face value) which has a coupon rate of 10%: you get $500 a year -- a yield of 10%. If, however, you buy that same bond at a discount (less than the face value), say $4,500, you still get the $500 a year interest, but the yield has now increased to 11.1%. The larger the discount, the bigger the yield. But if you buy the bond at a premium (more than the face value), say $5,500, you still get the $500 a year interest, but now the yield is only 9.1%. The larger the premium, the lower the yield.

Yield to maturity. This is an even more accurate measure of a bond's true rate of return. It takes into account the interest rate in relation to the price, the purchase price versus the face value, and the number of years to maturity. Yield to maturity is not easy to calculate. Don't feel badly, however: even bond traders use computerized programs and special bond calculators to figure this one out.

Ideally, for you as an individual to invest successfully in the bond market, you should diversify by issuer and also by maturity. You do not want all your bonds to fall due on the same date, in case interest rates at that time are low. If you stagger the maturity dates by different years, you lessen this risk. Similarly, buying bonds of only one issuer is not without risk. What if a corporation, for example, loses a major contract or has senior management problems? The market value of your bonds might fall in value. As investing in bonds can cost anywhere from $5,000 to $50,000, the cost for this diversification is prohibitive and also requires considerable amounts of skill and time -- which probably rules out most of us in one way or the other.

Bond Funds

These funds invest in short-, medium-, and long-term bonds and debentures of federal, provincial, and municipal governments and major corporations. Short-term bond funds are usually grouped with mortgage funds because of their similar maturity dates, generally one to five years, of the investments held. The aim of a bond fund is to provide investors with maximum interest income and capital gains from buying and selling bonds. For investors requiring additional income on a regular basis, bond funds generally pay more frequently than individual bonds. Unlike with an individual bond, however, when you invest in a bond mutual fund, there is no maturity date and no guaranteed repayment of the cash you invest.

The biggest advantage of bond funds is without doubt the diversification you can get with limited amounts of money. Your $1,000, instead of buying one bond, now buys you a share in many bonds from a wide variety of issuers with varying interest rates and different maturities. This minimizes your risk: if some bonds do badly, the others may do well. Unlike an individual bond, a bond fund gives no fixed rate of interest. The rate of interest paid by a bond fund fluctuates depending on the interest paid by the bonds held. The role of the fund manager is to capitalize on these changing interest rates. An experienced fund manager will anticipate a decline in interest rates and hold longer-term bonds at the higher rates. Conversely, if rising interest rates are anticipated, the fund may switch to securities with shorter maturities. When these fall due, the fund is then able to reinvest at the higher rates. A bond fund will realize either a capital gain or loss depending on the investment decisions of the fund manager.

How Interest Rates Affect Bond Funds

Bond funds, similar to individual bonds, are influenced by interest-rate movements. When interest rates go up, bond prices and the unit prices of bond mutual funds go down. Conversely, when interest rates go down, bond prices and the unit prices of bond mutual funds go up.

First, let's look at what happens when you buy a bond. Assume that today you buy a $1,000 bond at par (paying the full face value) with a coupon rote of 10%. The next day interest rates drop to 9%. If you decide to sell your bond, another investor may be willing to pay a premium (an amount more than the face value), perhaps $50, because your bond now offers a higher rate of return -- 10% as opposed to 9%. If you sell, you receive $1,050, making a capital gain of $50. Of course, the opposite happens if interest rates rise, say to 11%. If you want to sell your 10% bond now, you have to offer it at a discount (an amount less than the face value). After all, if investors can now purchase a bond paying 11% interest for $1,000, they are not going to pay the same price for a bond paying only 10%. If you decide to sell, you may receive $950, realizing a capital loss of $50. If, however, you decide to hold your bond, you continue to collect interest at the coupon rote of 10% (regardless of whether current interest rates are higher or lower) and on maturity receive the full face value of $1,000.

Now let's look at a bond mutual fund. In this case, when interest rates go down, the unit price (NAV) rises. This means if you originally paid $1,000 for 100 units at a NAV of $10, these units may now be worth (say) $12 each. If you sell, you receive $1,200, making a capital gain of $200. If instead interest rates rise, your 100 units may now be worth only $9 each. If you sell, you receive $900, realizing a capital loss of $100. If, however, you stay with the fund, your income payments may increase if the fund manager is in a position to reinvest maturing bonds at the higher rates of interest.

Bond Funds and Risk

When choosing a bond fund, you should be aware of the risks involved. Credit risk is the possibility that the issuer of the bond will not make the interest payments or repay the principal on maturity. Government of Canada securities are perceived to have virtually no risk, followed by provincial government bonds and high-quality corporate bonds. Issuers with the least credit risk generally offer lower interest rates than higher-risk issuers. Market risk, in the case of bond funds, is the risk that the value of your investment will decrease due to rising interest rates. Short-term bonds have the least market risk, followed by medium- and long-term bonds. An "AAA" rating, the highest, which is given by the Canadian Bond Rating Service and Dominion Bond Rating Service, indicates a fund with the highest degree of protection for principal and interest. This rating is followed by AA, A, BBB, BB, B, CCC, CC, and C in descending order.

Bond Fund Returns

The average return for Canadian medium- and long-term bond funds over the five-year period to December 31, 1995, was 10.6%, and returns ranged from a high of 13.8% to a low of 6.0% -- a difference of 7.8%.

Income from bond funds is normally paid monthly or quarterly or can be reinvested in additional units. All Canadian bond finds are RRSP eligible.

Mortgage Funds

As with a bond fund, the aim of a mortgage fund is to provide regular income. This type of fund generally concentrates on residential first mortgages (the most secure type), guaranteed either by the Government of Canada or a Canadian bank, on prime residential properties located in major cities across Canada. It is therefore quite possible that you could invest in a fund holding your own mortgage. Most bank funds also guarantee to buy back any mortgages held. by the fund, should they default. Some funds also include commercial and industrial mortgages in their portfolios.

Any changes in income payments made by this type of fund reflect the maturity dates of the mortgages held. As mortgages within a fund's portfolio mature, the fund manager has to reinvest in new mortgages, which may provide a higher or lower rate of interest depending on current interest rates. Because fund managers rarely trade the mortgages they hold, capital-gains potential is low. On the plus side, mortgage funds tend to be less volatile than most bond funds because of the shorter maturity dates -- generally one to five years -- of the investments held. The exception is mortgages on industrial or commercial property, which often have longer maturities.

Mortgage Fund Returns

The average return for Canadian mortgage funds and short-term bond funds over the five-year period to December 31, 1995, was 8.8%, and returns ranged from a high of 10.4% to a low of 6.8% -- a difference of 3.6%.

Income from a mortgage fund is generated from the interest payments made on the mortgages held by the fund, and is usually paid monthly, quarterly, or semi-annually. All short-term bond and mortgage funds are RRSP eligible.

Key Points to Remember

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