Five things every bond fund investor should know

Bond fund jargon can confuse even experienced investors. But duration, credit quality, yield, total return, and net asset value are five key concepts that every bond fund investor should know.

Duration
Let’s start with duration. This is one of the most crucial factors in bond-fund investing, as a fund’s duration will play a large role in determining its volatility and its returns. Sadly, and somewhat shockingly, the FSA does not require bond funds sold in the UK to give investors any indication of their duration. This is a critical omission that leaves investors without any way to gauge a key risk factor.

Bond prices move inversely with interest-rates, and this effect becomes larger the longer the time left until a bond’s maturity.* Duration is simply a precise way of measuring the sensitivity of a bond to interest rate changes. It is the weighted average of the time remaining until payment of each of the bond’s coupons, with the more sophisticated “effective duration” adjusting for the impact of any options imbedded in the bond. The higher a fund’s duration, the more its price will change in response to shifts in interest rates. Duration is quoted in years, and represents the percentage change in the value of the bond that will occur for every one percentage point change in interest rates. For example, if a bond fund has a weighted average duration of 3.5 years, a 2% increase in interest rates would cause its price to fall by 7%. Conversely, a 2% decrease in interest rates would cause its price to rise by 7%.

Credit quality
Credit Quality is the other key item that will determine a bond fund’s risk level and performance. Again, this is an item that is missing from many fund reports and fact sheets. Why this omission is deemed acceptable frankly escapes us. You should know a fund’s credit exposure before you invest. Bond issuers are rated by various private agencies, including S&P and Moody’s, which attempt to ascertain the creditworthiness of each issuer. In the S&P System, AAA ratings are considered the safest from default, and AAA, AA, A, and BBB are all “investment grade.” Ratings of BB or lower are considered “non-investment grade” and carry a higher risk of default (issues with these ratings are often referred to as “high-yield” or “junk bonds”).

All else being equal, lower-rated bonds pay higher levels of income than highly rated bonds—they must do this to compensate buyers for taking on the greater risk of default. However, if they default the holder of the bond can lose its entire investment. Investors should treat funds with large high-yield stakes with due care—they simply do not afford the same degree of safety as funds focused on higher-rated issues. At Morningstar, we place funds that typically have more than 40% in high-yield in our Morningstar Sterling High Yield, Dollar High Yield, or Euro High Yield categories.

Yield
Yield is a snapshot of the amount of income a bond fund pays to shareholders. It is often quoted in different ways—funds sometimes report a “running” or income yield, which is simply the annualised net income expected to be generated by the current portfolio of securities. Most also report “Redemption Yield” or “Yield to Maturity” which includes net income and also the capital appreciation expected if all bonds in the portfolio are held until maturity (an unlikely event). Whilst more realistic than running yield, redemption yield does not adjust for the potential impact of interest-rate shifts on the price of the bond over time, and should not be taken as an accurate picture of a fund’s future total returns (see below). At Morningstar, for the sake of consistency, we show a fund’s actual paid yield over the past 12 months. Yield can and does change daily based on portfolio changes and market conditions, but it provides one starting point for evaluating a bond fund's relative attractiveness.

The upside of either running yield or the 12-month yield we show is that it is easily understood. It's the money going into shareholders' pockets every month in the form of dividend checks or reinvestments. One downside to yield is that it changes daily based on bond market fluctuations and portfolio changes. In contrast, certificates of deposit allow investors to lock in rates (yields) for set periods of time. That's simply not the case with bond funds.

Total return
Perhaps the most important downside to all yield figures is that they don't capture the full investor experience—even redemption yield cannot take future rate interest rate changes into account, and as we saw by looking at duration, rate shifts can have a large impact on the value of a bond. One way investors can better evaluate a fund is by looking at its past total returns in conjunction with its current duration and credit risk. Total return includes both the income earned by a fund (yield) and any capital appreciation or depreciation of the fund's holdings. For example, assume a bond fund earns 5% in yield over the course of the next year. However, if interest rates move steadily higher, the prices of the fund's bond holdings are likely to fall. The net result, including the income paid and the capital depreciation, could well be a loss for shareholders.

Or consider a high-yield bond fund that offers a juicy yield but invests in very risky bond issues. If issuers default or high-yield bonds fall out of favour, as they did in 2001 and 2002, bond prices could drop dramatically. So, although investors might still earn a big yield, they might also be soaked with big losses overall.

Looking at a fund’s past total returns can tell you whether or not the manager has been forsaking capital appreciation or even permitting capital erosion—to maintain a fund’s yield. You can use this in conjunction with duration and credit quality to get a sense of the risk/reward profile of the fund.

Net asset value
Those principal changes are measured by changes in net asset value. Net asset value is simply the per-share amount of the value of all the holdings in a fund--essentially the price of a fund. If bond prices are rising, due to falling interest rates or improved issuer health, a bond fund's net asset value typically goes up. If bond prices are falling, bond fund net asset values typically go down. Bond prices change every day, so small fluctuations in net asset value aren't a concern.

However, if a fund's net asset value moves steadily lower over time, it can signal that management is sacrificing principal for yield (taking money out of one pocket and sticking it in the other) or that management simply does a poor job of picking bonds. Market conditions also play a role here. As interest rates trended higher in the first half of 2007, for example the average fund in our Sterling Corporate, Sterling Diversified Bond, Sterling Government Bond, and Sterling Global Bond categories all posted losses. Should rates trend higher for any extended period, we'd expect net asset values for these funds to move steadily lower.

Many investors contend that total return and net asset value are less important than yield, particularly for investors who take their dividends (yield) in cash and don't plan on selling their fund. After all, a loss isn't a loss unless it's realised. However, consider an investor who purchases 1,000 shares of a fund for £10 per share. If the fund yields 7%, the investor might earn £700 in yield over the course of a year. Now say the fund's net asset value dips to £9 per share. Even if the fund's yield moves up to 7.2%, the investor is now only earning £650 per year in yield. In simple terms, as a fund’s NAV erodes, its payout is likely to drop unless the manager takes on more credit risk or interest-rate risk to obtain higher-yielding issues.

The bottom line
Duration and credit quality are crucial factors in determining how much risk a bond fund is exposed to, and how it might behave in different market environments. Investors are often left without access to these details, but we think they should insist on having access to these figures before buying a bond fund. In evaluating bond fund performance, we tend to favour total return over yield, as we think it does a better job of measuring a fund's overall success or failure. That's not to say yield should be ignored, though, as it can be a meaningful measure of a fund's relative attractiveness. Meanwhile, net asset value, which is printed daily in many newspapers, is a good way to keep tabs on a fund and its management. If investors are familiar with all five of these factors, they'll have an easier time evaluating and monitoring their various bond fund holdings and could avoid some potentially nasty surprises.

* To understand duration, recall that a bond is simply a loan: The original “buyer” of the bond is lending money to the bond’s issuer. In exchange, he receives interest payments—the bond’s “coupon”—which constitutes the yield. The period of time before the loan must be repaid is the bond’s maturity. The value of the bond at any point in time depends on the present value of all future interest payments the issuer must make. More explicitly, that present value depends on the prevailing interest rate at the time the bond is being valued, and the length of time left until the bond matures.

The current interest rate is important because bond buyers will pay more for bonds whose coupons match or exceed the current rate, and will pay less for bonds that offer reduced interest. The key here is that bond coupons are structured as a percentage of the original loan amount, and do not fluctuate with market rates (in most cases). Thus, if you purchase a bond from the issuers for £100, and it pays a 10% coupon, it will pay you £10 per year. If the prevailing interest rate changes to 8%, the bond will then be worth more than £100 because it offers more interest than buyers can get elsewhere. But, if the interest rate rises to 12%, the bond will fall in value, as its rate of interest is less than the market norm. A bond’s maturity figures in because it determines the length of time the bond’s buyer will benefit or suffer from an above- or below-market rate of interest. The longer the time period until maturity, the greater the impact of a change in rates on the value of the bond.

This article was originally published January 28, 2008.