Bonds 103: Learning the Differences Between Bonds and Bond Funds
- How to assess return potential and risk
- Impact of fees
How can investors assess return potential?
When assessing the investment merits of a bond, one of the first things an investor is likely to consider is its return potential. Unlike equities, for which you can examine past performance, with bonds you need to consider the future return based on yield to maturity. The higher the yield to maturity, the greater the return offered.
This is reasonably straightforward for an individual bond because the data on the bond’s value, coupon and maturity is easy to ascertain. Provided you hold the bond until its maturity, the yield to maturity (expressed as an annual percentage) is a reasonably accurate calculation of a bond’s return that can be used to compare bonds.
When it comes to bond funds, however, it’s a little more complicated because the fund contains many investments each with different characteristics. As a consequence, the yield to maturity of a bond fund represents the average of all the yields offered by all the individual bonds in the portfolio.
Yield to maturity is not as reliable for bond funds because the bonds are not always held until maturity. Instead, the manager may choose to sell them in order to buy more attractive securities.
How can investors assess risks?
Investors should consider the risks associated with bonds, including interest rate risk, credit risk and foreign exchange risk. Comparing these risks across the different bonds or bond funds in conjunction with the yield information set out above, can help you understand bonds’ risk-return profiles.
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INDIVIDUAL BONDS |
BOND FUNDS |
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Interest rate risk A bond’s sensitivity to changes in interest rates |
Duration can be used to assess the sensitivity of different bonds to interest rate changes. Expressed as a number of years, the higher the duration the higher the sensitivity. For example, duration of 4 years means the bond will drop 4% for every 1% increase in interest rates. A duration of 1 year means the bond will drop 1%. |
Bond funds can also be assessed using duration. However, they differ because the portfolio is constantly being reinvested and never matures. Bond managers seek to manage the duration of the portfolio within a certain range. Bonds are designed to have short and long duration. |
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Credit risk Likelihood the bond issuer will default on payment obligations |
Bonds are assessed and given credit ratings by independent credit rating services. These ratings can help investors compare different bonds and the likelihood of default. The higher the rating, the lower the risk of default. |
Bond funds offer different degrees of credit risk depending on the stated investment objectives. Some will invest in investment grade securities only, while others take on more risk. It’s important to understand these risk parameters when choosing a bond fund. You may see this referred to as the “weighted average credit rating.” |
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Foreign exchange risk The impact of currency fluctuations |
For investors buying bonds outside their home jurisdictions, it is important to consider the potential impact of currency fluctuations on return. |
Investors buying bond funds that have foreign currency exposure should assess the manager’s approach to managing currency risk. |
What’s the impact of fees?
When assessing bond funds, it is important to consider the different fees charged by the fund managers. The expense ratio is a commonly used measure that sets out what it costs the fund manager to operate the fund.
When comparing expense ratios of different funds, it’s important to weigh carefully what you are getting for your money. At first glance, passive funds may appear better value because they have lower expense ratios.
However, in return for higher fees, active fund managers are often able to take advantage of short- and long-term trends and manage risks with the goal of delivering better returns to investors. As the chart below shows, the median active bond manager outperformed the median passive manager and the benchmark, after fees, in the 10 years to 31 December 2023. As a general rule, a passive manager’s return equals the benchmark’s return minus fees.
10-Year Medium Returns of U.S. Active and Passive Managers
Source: Morningstar as of 31 December 2023. Based on Morningstar U.S. Fund Intermediate Core and Intermediate Core-Plus categories. Institutional share class. Benchmarks: Fixed Income = Bloomberg U.S. Aggregate Index. Equities = S&P 500 Index.
Past performance is not a guarantee or a reliable indicator of future results. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. Other time periods will have different results.
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