Many mutual funds invest in bonds for risk-averse investment. you need to study ratings to understand risks involved
Declining returns and unpredictable life situations force us to look at new and different investment opportunities. The very same reasons motivate us to ensure the stability and reliability of our investments. Bonds are relatively safer investment for common investors because they provide fixed returns. Unlike stocks where the returns depend on market forces, the company’s growth, prevailing economic situation, among others, bonds mostly stay unaffected by these events.
Rating of bonds
Every bond product has to mandatorily go through a rating process by rating agencies such as CRISIL, ICRA, and CARE. The rating agencies visit the company, speak to company officials, collate information, analyse the data collected, look at the past records, and provide a rating to the bonds offered. The purpose of rating is to evaluate a company’s financial position to identify whether it can meet the interest and principal obligation to its bond investors. A company offering a highly rated bond is financially strong enough to pay its obligation. As the rating goes down, the probability of default by the company increases.
Let us look at some important factors in bond evaluation
Financial risk: Does the company have enough resources to pay its obligation? Can the forecasted income of the company be relied upon? These aspects indicate a company’s financial health are factored in to calculate financial risk.
Business risk: Does the company face business risk that may hamper its ability to pay the interest and principal? The risk can be in terms of general profitability and prospect of the industry, its market position, competition, government regulation, monsoon, litigation, etc.
Management evaluation: Does the management have the integrity and competence to manage the project for which bonds are issued? Governance issues such as these go into evaluating the management that is steering the company.
Fundamentals: Does the company have a dependable overall presence? This includes overall efficiency of the company which looks at profitability, cash situation, its power on pricing, and its competitive position.
Rating versus returns
Since bonds vary in rating and thus risks, the returns also vary in tandem. A low-risk or highly rated bond promises a lower interest rate than a riskier bond.
How do mfs fit into the picture?
Mutual funds invest equity and bonds depending upon the risk-return combination. There are a class of MFs that invest in bonds, known as bond funds or balanced funds. Balanced funds invest in both equity and bonds while bond funds primarily invest in bonds.
So the ability of bond funds to yield returns depends on the underlying bonds that the fund invests in.
(The writer is the CEO of BankBazaar.com)
How should investors select the bond fund?
Investors can see the bonds and associated rating of the bond underlying the mutual fund. This helps investors select the right mutual fund for investment. The rating given by agencies captures all the risks and promises at the time of launching the bond.
While rating is important, investors should also consider their time horizon and risk profile. Bond funds are low-risk investment but they also provide lower returns than equity funds. At the same time, equity funds do not offer a fixed and time-bound return. A risk-averse investor not comfortable with the market fluctuation should select bond funds.
Additionally, investors should also consider the exposure of bond funds to different sectors. A bond fund heavily invested in a particular sector exposes its investors to the sectoral risk. For example, an infrastructure bond fund faces the risk of delays in land acquisition and adverse government regulation. Similarly, a bond fund heavily invested in real estate faces the risk of slowdown in economy. These events may force companies to delay their payments or completely default on their obligation.
Finally, bond funds invest in different types of bonds such as government bonds, corporate bonds and their different variants. The government bonds are the safest. That is why they are also known as risk-free investment and their returns are called risk-free rate. Corporate bonds are not without risk simply because they have to earn money to pay their investors, unlike the government, which can print money to pay the investors in the worst case. However, high-grade corporate bonds offered by big industrial houses are very low risk and they provide better returns than government bonds. Investing in bonds, both government and corporate, can be a safe way to get assured returns. But make sure that you do enough research about the dependability of the bond before investing so that you can get the maximum benefits with very little worry.
( Source : deccan chronicle )
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