The best attributes of bonds and funds combined
In a world of record-low interest rates and slowing economic growth, fixed-maturity bond funds remain an attractive proposition for investors looking to combine a yield pickup and a relatively predictable, regular stream of income.
The relentless decline in bond yields is expected to end. However, gradually rising yields imply that investors in government and investment-grade corporate bonds are likely to be left with a very meager return outlook. So those investors need to pay more attention to higher-yielding market segments such as emerging markets, intermediate-quality bonds and selected high-yield securities. Individual bonds in these segments offer above-average yield opportunities and other benefits, including a fixed-term investment period, regular interest payments, and potential repayment of invested capital at par if the bonds are held to maturity. But they also involve higher risks. For example, a debtor default could result in a significant loss for an investor with an insufficient degree of diversification.
Investing in bond funds can significantly reduce the impact of a potential issuer default on the overall investment. However, since they have no maturity date, they offer investors little protection against potential interest-rate increases, and future interest payments can be difficult to predict. For these reasons, investors may choose to invest in a well-diversified fixed-maturity bond fund instead. This investment solution combines the benefits of bonds and investment funds.
Cash flow characteristics of a bond and broad diversification
Funds with a short, predetermined maturity enable investors to achieve their desired total return while limiting interest-rate and spread risks of their investments. Like individual bonds, fixed-maturity bond funds mature on a specified date and the accumulated capital is repaid to investors. Like investment funds, they are professionally managed and offer daily liquidity. They are also broadly diversified and operate within a regulated framework.
Fixed-maturity bond funds only invest in bonds that mature before or on the fund's own maturity date. Since the fund's interest-rate and credit spread duration decreases steadily over its term, the portfolio's risk and volatility are reduced accordingly. As a result, the negative impact of a potential interest-rate shock happening near the fund's maturity date is significantly reduced. Similar to a bond investment, investors can choose to receive payouts at regular intervals.
At the same time, the portfolio management team ensures ongoing active credit monitoring. Bonds whose credit quality deteriorates are sold and replaced. If the price of a bond reaches an attractive level for profit-taking, the security may also be sold and replaced with a more attractive one.