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Be Wise With Money

Bond Fund Basics: How Fund Managers Seek to Add Value

Ever wonder how managers of bond funds earn their keep?

On the surface, their job seems pretty straightforward. Buy a bond that pays a specified rate of interest. Pocket that interest until the bond matures, then get your principal back. Repeat.

Sure, bond fund managers have to do some homework. They want to buy bonds from issuers with the financial strength to pay all the promised interest, and to repay the original investment once the bond matures. They also want the yield on the bonds they own – the interest the bonds pay as a percentage of their cost - to be commensurate with the risk that the issuer won’t be able to meet its obligations.

If that was all there was to it, being a good bond fund manager would still take considerable talent. Reliably forecasting who will be able to pay their debts 10, 20, maybe even 30 or more years into the future is no small feat. But the task can actually be quite a bit more complicated. Fund managers must weigh not only a bond’s credit risk – the risk that the issuer might default – but also a host of other risks, including:

  • Interest rate risk. If interest rates go up, a bond’s value will fall. Why? Because investors could now earn more interest on a comparable new bond. (This principle also works in reverse: When interest rates fall, bond prices go up.)
  • Inflation risk. Every uptick in inflation reduces the purchasing power of a bond’s interest payments.
  • Call risk. Some bonds are “callable,” meaning the issuer can redeem them before they mature. This usually happens when interest rates have fallen substantially and the issuer can borrow more cheaply by selling new bonds.
  • Reinvestment risk. This is the risk that a bond’s proceeds will have to be reinvested at a lower rate of return because of a decline in interest rates.
  • Liquidity risk. Sometimes a bond manager will want to sell a bond quickly but be unable to do so because there aren’t many interested buyers. The chance of this happening is called liquidity risk, and it can lead to selling at a loss. It’s typically not an issue with U.S. government bonds, where there is almost always a liquid market, but it can be a problem with some corporate or municipal bonds.


With so many variables at play, bond managers use a wide variety of strategies to try to boost the performance of their funds. Here are three of the most common:

  • Tactical allocations to multiple sectors of the bond market. Many investors think of the bond market as a monolithic entity dominated by U.S. Treasury bonds, which capture most of the financial news headlines. But bond fund managers can actually choose from a far broader menu of investment options that also includes corporate bonds, mortgage-backed securities, high-yield debt, international bonds, and, in some circumstances, preferred stocks and convertible bonds. By tweaking how much they allocate to each sector – within the limits set out in their fund’s prospectus – fund managers can diversify both the risk in their portfolios and the number of opportunities to capture yield. Exact allocations will depend on the manager’s assessment of the risk factors listed above, plus market valuations – how cheap or expensive each sector of the market is at the moment.
  • Adjusting the fund’s sensitivity to interest rates. As noted earlier, bond prices fall when interest rates go up and vice versa. But not all bonds react to interest-rate changes at the same rate. In general, the longer the period until a bond matures, the more its price will move when rates move. Depending upon the bond fund manager’s outlook for interest rates, he or she may choose to allocate more or less of the fund’s portfolio to the shorter or longer end of the maturity spectrum. Fund managers talk about this in terms of moving in or out on the yield curve, which is the line formed by plotting, from left to right, the yields on bonds with increasingly longer maturities. In normal economic environments, the line rises from left to right because yields tend to rise as maturities lengthen. This compensates owners of longer-maturity bonds for taking the risks of bond ownership for longer periods of time.
  • Trading bonds prior to their maturity date. Once they are issued, bonds, like stocks, trade in a secondary market where their value can fluctuate in response to changes in the risk factors outlined above. As prices shift, managers will sometimes find it advantageous to sell a bond before it matures. If a bond’s value increases due to a decline in interest rates, for example, selling at a profit could yield better returns than simply continuing to collect interest payments. If rates are rising, selling might help the fund avoid capital losses. The manager also might sell if a bond issuer’s credit quality appears to be deteriorating, or to invest in a new bond offering less credit risk or a better yield. The manager also might sell if a bond’s age means that it no longer fits with the fund’s investment guidelines – for example, if a 10-year bond in a long-term bond fund is eight years old and now trades like a two-year bond.

To make the fund manager’s job still more complicated, most bonds do not trade on a central exchange where prices are readily visible. Instead, they trade “over the counter” between bondholders directly or through bond dealers or the bond trading desks of major investment banks. Staying on top of all the variables is challenging work. The experience and expertise the manager brings to the task can have a significant impact on a fund’s performance.

 

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