Last month, we gave an overview of bond funds in our post entitled “What is a bond mutual fund?”. Unique to bond investing are the concepts of “quality” and “maturity” of a bond. Here is a brief primer on these important aspects of bond fund research.
What is the “quality” of a bond?
Quality refers to the likelihood that a bond will pay interest and repay principal as scheduled. Generally, the higher a fund’s average bond rating, the less credit risk an investor will face. Rating services such as Standard & Poor’s, give bonds ratings which range from AAA (the highest quality) to BBB and lower. Bonds rated below BBB are known as “junk” bonds because there is a greater possibility that payment obligations will not be met. Since these bonds generally pay more to compensate for this increase in risk, they are also known as high-yield bonds.
By way of concrete examples, the TCW Total Return Bond (TGLMX ) is a bond fund with a high quality rating. The Fund will invest primarily in mortgage-backed securities of any maturity or type guaranteed by or secured by collateral that is guaranteed by the United States Government, its agencies or sponsored corporations, or in privately issued mortgage-backed securities rated at time of investment AA or higher by Moodys or S&P. By contrast, Buffalo High Yield Fund (BUFHX) is a high yield fund with a low quality rating – the fund normally invests at least 80% of net assets in higher-yielding high-risk debt securities rated below investment-grade by the major rating agencies. It may also invest in preferred stocks, convertible preferred stocks and convertible debt securities.
This should give you a sense of the different level of risk attaching to various bond funds and how the quality rating can give you an indication of the risks involved.
What is a bond’s “maturity”?
Maturity refers to the date at which a bond’s principal is due to be repaid. A fund’s average maturity is the dollar-weighted average of the maturities of the bonds it holds. Because longer maturity bonds are more exposed to interest-rate changes, long-term bond funds are typically considered to be more risky than short-term bond funds.
To understand why changing rates move bond prices, here’s a simple but useful example from www.winninginvesting.com: Say you bought a newly issued $1,000 bond paying 6% annual interest, which amounts to $60 per-year. Suppose that subsequent to your purchase the prevailing interest rate increases and similar bonds now offer 7%, or $70 annually. If you wanted to sell your bond, nobody would pay you $1,000 to get $60 interest when the going rate is $70. Instead, you’d have to reduce your price to the point where its $60 interest payment amounts to 7% return, in this case, $858.
Factoring quality and maturity into your investment objectives
Generally, more conservative investors favor funds with high average bond quality, since this reduces credit risk. Other investors may be willing to accept lower average bond quality in exchange for the opportunity to earn higher returns. By the same token, specifying bond funds with a particular average maturity can help you manage your interest-rate risk.
With equity markets still in a stage of extreme volatility, combined with bank deposit rates being virtually zero, it’s a good time to be focusing on bonds as a key component of your mutual fund analysis.
