Understanding Bond Funds in Stock Market

5.1 About Bond Funds

So what is a bond? Let me try to explain with an analogy. If a money market fund is like a savings account, then a bond is similar to a certificate of deposit (CD). With a five-year CD, for example, a bank agrees to pay you a predetermined annual rate of interest - such as, say, 4.5 percent. If all goes according to plan, at the end of five years of earning the 4.5 percent interest, you get back the principal that you originally invested.

Bonds work about the same way, only instead of banks issuing them, corporations or governments issue them. For example, you can purchase a bond, scheduled to mature five years from now, from a company such as Reliance. A Reliance five-year bond may pay you, say, 6 percent. As long as Reliance, doesn't have a financial catastrophe, after five years of receiving interest payments (also known as the coupon rate) on the bond, Reliance returns your original investment to you (Note: Zero coupon bonds pay no interest but are sold at a discounted price to make up for it.)

The worst that can happen to your bond investment is that, if Reliance filed bankruptcy, then you may not get back any of your original investment, let alone the remaining interest.

5.2 Bond Fund Investing

• Bonds can be safer than you think- Many companies need to borrow money (and thus issue bonds) and are good credit risks. If you own bonds in enough companies - say, in several hundred of them - and one or even a few of them unexpectedly take a fall, their default (failure to pay back interest or principal on time) affects only a sliver of your portfolio and wouldn't be a financial catastrophe. A bond mutual fund and its management team can provide you a diversified portfolio of many bonds.

• You're rewarded with higher interest rates than comparable bank investments. The financial markets and those who participate in them - people like you and me - aren't dumb. If you take extra risk, you should receive a higher rate of interest investing in bonds. Guess what? All the Nervous Nellie savers who're comforted by the executive desks, the vault, the guard in the lobby, and the deposit guarantee logo at their local bank should remember that they're being paid less interest at the bank because of all those comforts.

• Bond alternatives aren't as safe as you might like to believe. Any investment that involves lending your money to someone else or to some organization carries risk. That even includes putting your money into a bank or buying a Treasury bond issued by the federal government. (Although I'm not a doomsayer, any student of history knows that governments and civilizations fail. It's not a matter of whether they will fail; it's a question of when)

5.3 Four Key Facts of Bond Mutual Fund

Bond funds aren't as complicated and unique as people, but they're certainly more complex than money market funds. However, after you know four key facts about bond funds - maturity, credit rating, the different entities that issue bonds, and, therefore, the tax consequences on those bonds - you can put the four together to understand how mutual fund companies came up with so many different types of bond funds. For example, you can buy a corporate intermediate-term high-yield (junk) bond fund, or a long-term municipal bond fund.

Maturity: Counting the years until you get your principal back

In everyday conversation, maturity refers to that quiet, blessed state of grace and wisdom that you develop as you get older (ahem). But that's not the kind of maturity we are talking about here. Maturity, as it applies to bonds, simply refers to when the bond pays you back - it could be next year, 5 years from now, 30 years from now, or longer. Maturity is the most important variable by which bonds, and therefore bond funds are differentiated and categorized.

You should care plenty about how long a bond takes to mature because a bond's maturity gives you a good (although far from perfect) sense of how volatile a bond will be if interest rates change. As bond prices and interest rates are inversely related. If interest rates fall, bond prices rise.

Bond funds are portfolios of dozens - and in some cases hundreds - of individual bonds. You won't need to know the maturity of every bond in a bond mutual fund. A useful summarizing statistic to know for a bond fund is the average maturity of its bonds.

Bond funds usually lump themselves into one of three maturity categories:

• Short-term bond funds: These funds concentrate their investments in bonds maturing in the next few years.
• Intermediate-term bond funds: This category generally holds bonds that come due within five to ten years.
• Long-term bond funds: These funds usually hold bonds that mature in 15 to 20 years or so.

The above definitions aren't hard and fast. One long-term bond fund may have an average maturity of 14 years while another may have an average of 25 years. You can run into problems when one intermediate-term fund starts bragging that its returns are better than another’s. It's the old story of comparing apples to oranges. When you find out that the braggart fund has an average maturity of 12 years and the other fund has a maturity of 7, then you know that the 12-year fund is using the "intermediate-term" label to make misleading comparisons. The fact is, a fund with bonds maturing on average in 12 years should be generating higher returns than a fund with bonds maturing on average in 7 years. The 12-year fund is also more volatile when interest rates change.

The greater risk associated with longer-term bonds, which suffer price declines greater than do short-term bonds when interest rates rise, often comes with greater compensation in the form of higher yields. Most of the time, longer-term bonds pay higher yields than do short-term bonds.

Duration- Measuring interest rate risk

If you're trying to determine the sensitivity of bonds and bond funds to changes in interest rates, duration may be a more useful statistic than maturity. A bond fund with a duration of ten years means that if interest rates rise by 1 percent, then the value of the bond fund should drop by 10 percent. (Conversely, if rates fall 1 percent, the fund should rise 10 percent.)

Trying to use average maturities to determine what impact a 1 percent rise or fall in interest rates will have on bond prices forces you to slog through all sorts of ugly calculations. Duration is no fuss, no muss - and it gives you one big advantage, too. Besides saving on number crunching, duration enables you to compare funds of differing maturities. If a long-term bond fund has a duration of, say, 12 years, and an intermediate fund has a duration of 6 years, the long-term fund should be about twice as volatile to changes in interest rates.

Although duration is easier to work with and a better indicator than average maturity, you're more likely to hear about average maturity because a fund's duration isn't that easy to understand. Mathematically, it represents the point at which a bondholder receives half (50 percent) of the present value of her total expected payments (interest plus payoff of principal at maturity) from a bond. Present value adjusts future payments to reflect changes in the cost of living.

If you know a bond fund's duration, which you can obtain from the fund company behind the bond fund you're interested in, you know almost all you need to know about its sensitivity to interest rates. However, duration hasn't been a foolproof indicator: As interest rates have risen, some funds have dropped more than the funds' durations predicted.

Credit quality: Determining whether a bond fund is dependable

Bond funds also differ from one another in terms of the creditworthiness of the bonds that they hold. That’s just a fancy way of saying, "Hey, are they gonna stiff me or what?" Every year, bondholders get left holding nothing but the bag for billions of rupees when their bonds default. You can avoid this fiasco by purchasing bonds that are unlikely to default, otherwise known as high-credit-quality bonds.

Credit rating agencies - Moody's, Standard & Poor's, Duff & Phelps, and so on - rate bonds based on credit quality and likelihood of default. The credit rating of a security depends on the company's (or the government entity's) ability to pay back its debt. Bond credit ratings are usually done on some sort of a letter-grade scale: For example, in one rating system, AAA is the highest rating, with ratings descending through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on. Funds that mostly invest in:

AAA and AA rated bonds are considered to be high-grade or high-creditquality bond funds; bonds of this type have little chance of default. These bonds are considered to be investment quality bonds.

A and BBB rated bonds are considered to be general bond funds (moderate-credit-quality). Like AAA and AA rated bonds, these bonds are known as investment quality bonds.

BB or lower rated bonds are known as junk bond funds (or by their more marketable name, high-yield funds). These funds expect to suffer more defaults - perhaps as many as a couple of percent of the total value of the bonds per year or more. Unrated bonds have no credit rating because they haven't been analyzed or evaluated by a rating agency.

Lower-quality bonds are able to attract bond investors by paying them a higher interest rate. The lower the credit quality of a fund's holdings, the higher the yield you can expect a fund to pay (to hopefully more than offset the effect of potential defaults).

Issuer: Knowing Who You're Lending To

Bonds also differ according to which type of entity is issuing them. Here are the major options:

• Treasuries: These are instruments from the biggest debtor of them all - the Indian government. Treasuries include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years).

• Municipals: A municipal bond (muni) is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. Through muni bonds, a municipal corporation raises money from individuals or institutions and promises to pay a specified amount of interest and returns the principal amount on a specific maturity date. These are mostly exempt from federal taxes and from most state and local taxes, making them especially attractive to people in high income tax brackets.
• Corporates: Issued by companies such as Reliance Industries & Tatas, corporate bonds pay interest that's fully taxable.
• Convertibles: These are hybrid securities - bonds that you can convert into a preset number of shares of stock in the company that issued the bond. Although these bonds do pay interest, their yield is lower than nonconvertible bonds because convertibles offer you the upside potential of being able to make more money if the underlying stock rises.

5.4 Why you might (and might not) want to invest in bond funds

Investing in bonds is a time-honored way to earn a better rate of return on money that you don't plan to use within at least the next couple of years. As with other mutual funds, bond funds are completely liquid on a day's notice, but generally one should view them as longer-term investments. Because their value fluctuates, you're more likely to lose money if you're forced to sell the bond fund sooner rather than later.

In the short term, the bond market can bounce every which way; in the longer term, you're more likely to receive your money back with interest. Don't invest your emergency money in bond funds - use a money market fund instead. You could receive less money from a bond fund (and could even lose money) if you need it in an emergency. You also shouldn't put too much of your longer-term investment money in bond funds. With the exception of those rare periods when interest rates drop significantly, bond funds won't produce the high returns that growth-oriented investments such as stocks, real estate, and your own business can.

Some common financial goals to which bond funds are well suited:

• A major purchase: But make sure that the purchase won't happen for at least two years, such as the purchase of a home. Short-term bond funds should offer a higher yield than money market funds. However, bond funds are a bit riskier, which is why you should have at least two years until you need the money to allow time for recovery from a dip in your bond fund account value.

• Part of a long-term, diversified portfolio: Because stocks and bonds don't move in tandem, bonds can be a great way to hedge against declines in the stock market. In fact, in a down economic environment, bonds may appreciate in value if inflation is declining. Different types of bond funds (high-quality bonds and junk bonds, for example) typically don't move in tandem with each other either, so they can provide an additional level of diversification.

• Generating current income: If you're retired or not working, bonds are better than most other investments for producing a current income stream.