Fixed income funds can offer a way to achieve diversification, even with a small investment.
Fixed income as an asset class comprises a variety of different types of securities; bonds are the most commonly known kind. In the marketplace, “fixed income” and “bonds” are usually used interchangeably to refer to the same thing. Other examples of fixed income instruments include mortgage-backed securities, asset-backed securities and convertible debt.
For many investors, a fixed income fund is a more efficient way of investing than buying individual fixed income securities. Fixed income mutual funds are just like stock mutual funds, in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are. Some fixed income funds aim to mimic the broad market, investing in short- and long-term fixed income securities from a variety of issuers, such as the Canadian government, government agencies, corporations and other more specialized securities. Other fixed income funds, such as a short-term fund or a high-yield fund, focus on a narrower slice of the debt market.
Whether the fund’s mandate is broad or narrow, a fixed income fund typically invests in many different securities – often buying and selling according to market conditions and rarely holding securities until maturity – so it’s an easier way to achieve diversification, even with a small investment. Income payments are generally made monthly and reflect the mix of all the different fixed income securities in the fund and the payment schedule of each. Accordingly, the distribution may vary from month to month.
Advantages of fixed income funds
Diversification
Fixed income funds typically own a number of individual securities of varying maturities, so if an issuer should fail to pay interest or principal, the impact of that single security’s performance is lessened. Certain types of fixed income funds, such as broad market funds, are also diversified across fixed income sectors, providing exposure to corporate, government, government agency and mortgage-backed securities. The investment minimums for most fixed income funds are low enough that you can get significantly more diversification for much less money than if you purchased individual securities.
Professional management
Professional portfolio managers and analysts have the expertise and technology to research the creditworthiness of bond issuers and analyze market information before making investment decisions. Fund managers identify which securities to buy and sell through individual security analysis, sector allocation and yield curve evaluation.
Liquidity and convenience
Many fixed income funds allow you to buy or sell your fund units each day. In addition, fixed income funds allow you to automatically reinvest interest income and to make additional investments at any time.
Income stream
Most fixed income funds pay regular monthly income, although the amount may vary with market conditions. This feature can make fixed income funds an appropriate choice for investors who desire somewhat stable, regular income. If you do not wish to receive the monthly income, you can choose to have that income reinvested automatically.
Risks of fixed income funds
Interest rate risk
If interest rates rise, bond prices usually decline, and if interest rates decline, bond prices usually rise. This inverse relationship is important to understand. The longer a bond’s maturity, the greater the bond’s interest rate risk. A fixed income fund with a longer average maturity will see its net asset value (NAV) react more dramatically to changes in interest rates as the prices of the underlying bonds in the portfolio increase or decline. The effect that interest rates have on the prices of fixed income securities owned by the fund will cause the income that the fund distributes each month to vary.
Credit risk
Fixed income funds are typically classified as either investment-grade quality (medium to high credit quality) or below-investment-grade quality, depending on the individual securities in which they invest. (The fixed income securities that funds own each carry the risk of default if the issuer is unable to make further income or principal payments.) Many individual securities are rated by a third-party rating agency, such as Moody’s or Standard & Poor’s, to help describe the creditworthiness of the issuer. Credit risk is a greater concern if a fund, such as a high-yield fund, invests in lower-quality fixed-income securities. The fund’s prospectus will describe its credit quality policies.
Principal risk
When you sell units of a fund, you receive the fund’s current net asset value (NAV), which is the value of all the fund’s holdings divided by the number of fund units. If the fund’s NAV is lower on the day you sell units than it was when you purchased them, you could lose some or all of your initial investment.
Other risks
Other risks typically associated with fixed income investing, such as default risk and call risk, are mitigated because a fixed income fund is made up of many individual bonds. Because a fund owns 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.
Measuring fixed income fund performance
The performance of a fixed income fund is determined by the performance of its underlying investments, but there are a few factors specific to fixed income funds that will affect its performance and your investment. As with all investments, remember that past performance is not a guarantee of future results.
Unit price
Every fixed income fund has a net asset value (NAV), or unit price, which is the dollar value of one unit of the fund. The NAV is based on the value of all the securities in the portfolio and typically fluctuates daily.
Yield
The yield of a fixed income fund is a measure of the income received from the underlying securities held by the fund. Yield is the anticipated return on an investment, expressed as an annual percentage. For example, a 6% yield means that the investment averages a 6% return each year. There are several ways to calculate yield, but whichever way you calculate it, the relationship between price and yield remains constant: The higher the price you pay for a bond, the lower the yield, and vice versa.
Total return
A fixed income fund’s total return is the measure of its overall gain or loss over a specific period of time. Total return includes income generated by the underlying bonds and price gains or losses (both realized and unrealized). Investors should focus on total return when evaluating the performance of fixed income funds.
