FOOL'S EYE VIEW
Investing in Bond Funds

By James Carlisle
February 15, 2002

Bond funds are selling like hot cakes. Industry figures show that their share of unit trust sales increased from 12% in 2000 to 19% in 2001. At the same time, the proportion going into shares fell from 81% to 71%. It's no surprise really, with everyone taking fright at the stock market at the moment. But just because everyone's doing something doesn't make it a good idea. In fact, in financial matters, if you find that you're moving with the crowd, it's often a good time for a re-think. It's no co-incidence that technology funds were the hottest selling funds at the peak of the 'technology bubble' a couple of years ago.

What are bond funds?

Bond funds can come with a variety of different names, but generally you'll see words like 'High' and 'Extra' coming before 'income' or 'yield', with maybe 'bond fund' or 'fixed interest trust' tacked onto the end. The basic point of them is that they take your money and use it to buy and sell bonds.

Bonds are basically like IOUs handed out by governments and companies in exchange for the money they borrow. How risky any particular bond is will depend on who's handing them out. Just as an IOU from Great Aunt Agatha is more reliable than 'I'll get you one when I next see you' from that bloke down the pub, a bond issued by Tesco is going to be more reliable than a bond issued by NetNachos.com. To make up for the fact that it's more likely to go bust, NetNachos will have to pay a higher rate of interest on its bonds. So, while you might settle for 6% per year from Tesco, you might expect 10% (at the very least!) from NetNachos.

It's not just the company going bust that you have to worry about, though. Bonds are traded and their price varies according to interest rates in the overall economy. So, if interest rates in general go up, then the 10% per year you were getting from NetNachos isn't quite so good any more, relative to everything else, and the price of the bonds in the open market will go down.

Of course, bond funds spread themselves about over lots of different bonds, but the risks are still there and, if the economy is such that one company goes bust, there's a good chance that others will too. Not only that, but the higher the rate of interest that a bond fund offers, the more risky the underlying bonds will be.

Are bond funds a good idea?

It's typical of human nature that we tend to shy away from the stock market when it's had a couple of bad years. But it really doesn't make sense. We have no way of knowing where the stock market's heading and certainly what's happened over the last couple of years is no indicator. After all, at the end of 1999, we'd just had a couple of excellent years and everyone was piling into shares. And that's been followed by this bad patch.

You might even say that the recent poor performance from the stock market is actually happening because people are being nervous about buying shares. It's a chicken and egg situation really. Shares have done badly because people are shying away from buying them and people are shying away from buying them because shares have done badly. We don't know how long it'll be before this cycle breaks and we don't know how long it will be then before it starts again. In short, it's a mug's game trying to chase other investors around.

Where you put a particular bit of your money should depend on the balance of risk and return that you want for it. So what sort of money should go into bond funds?

It shouldn't be your emergency reserve of cash, because that needs to be kept safe and accessible in case of that emergency. The only real answer for this is some form of bank or deposit account. It also shouldn't be your long-term savings because, for long time periods, a spread of shares tends to be the best home for your money.

So, if there is any room for a bond fund, it must be for some sort of medium-term investment. Perhaps where you're saving up for something around five or six years away. Where you're prepared to take a little extra risk than a bank account, but not as much as shares.

It's very hard to say, though, how much risk there is in any particular bond fund, except to say that the greater the returns that they apparently offer, the more risky they're likely to be. Not only that, but the charges eat into a lot of the extra return that you were taking on the risk to get. It all rather defeats the object.

Call me old fashioned, but it seems to me that either you can accept some risk or you can't. Where you can't, then you'll be wanting cash and, where you can, then you'll be wanting shares. If you really do want 'a little risk but not too much' for a particular lump of money, then you can leave half of it as cash in the banks and put the other half in shares. In fact, you can vary your proportions according to how much risk you're happy with. It's very hard to see much room for a bond fund.

If you really want one

OK, so let's say you don't agree with me and have your heart set on a bond fund, what should you think about?

Most importantly, don't confuse them with ordinary bank or savings accounts. With a bond fund there will be a risk to your capital and income. What's more, the more interest you're being offered, the greater the risks will be. Think hard about whether you're happy to accept these risks. If not, then your money should stay in the bank.

Pay no attention to past performance figures. Because long-term interest rates have been generally falling over the last 10 years, bonds have done well. But there's no reason to suppose that long-term interest rates will continue to fall. They could as easily go up and that would send bonds down.

Know the difference between the 'running yield' and the 'redemption yield'. The 'running yield' tells you how much interest you're getting on the current value of your units. The redemption yield, on the other hand, tells you the overall return you can expect to get, taking into account gains and losses that the fund might make when the individual bonds mature (but ignoring the chances of companies going). The redemption yield is the figure to focus on, but remember that the higher it is, the riskier the bonds are.

Read the 'key features document' carefully. Every fund has to have one of these and the regulator makes sure that they tell you certain things. If the key features document doesn't make sense, then find one that does. The more complicated the fund is, the less likely it is to be any good.