Monday, October 24, 2005

Buying bond funds? Read this.

Many people thought that bond fund is a good vehicle for retirement planning. Though with low returns (usually slightly higher than the return from fixed deposits) many sided that it is safe. Conservative and prudent investors invest in such bond funds accepting low return for the comfort of knowing their capital is protected.

However, this is only partially true. The truth part is bonds give lower return than equity in long term. But lower risk? It depends, read on.

We can generalise bonds into two categories:
a. Bonds issued by government or Bank Negara, i.e. Merdeka Savings Bonds, Malaysian Government Securities, etc.
b. Corporate bonds

While government/ Bank Negara bonds are safe and with slight higher return for the investors, corporate bonds are almost as risky(t) as equity shares. Investing in corporate bonds, just like investing in equity shares, subjects to the risk(t) of corporate failure.
The Edge recently reported a case on Pesaka Astana’s failure to meet its first bond repayment that was due last September. Read this from TheEdgeDaily. The irony was that, just a year ago, MARC affirmed its bond rating at A+.

So, just think:
  • Bad shares have high downside risk(t), bad corporate bonds have high downside risk(t), too.
  • Good shares have high upside potential, good corporate bonds don’t have high upside potential.
It doesn't seem logical to invest in corporate bonds, does it?

Generally most government or Bank Negara bonds are hold tightly by insurance companies or financial institutions for their long term investment objectives. Such bonds are less liquid. (A better definition for Liquidity) They are usually bought and kept for long term by financial institutions. Whenever available for sales they are usually quickly snapped up by financial institutions.

Take a look of your bond funds or balance funds half yearly financial statements. You will probably realise that most of their bond investments are corporate bonds. And if this is really the case, your funds are subject to the same risk(t) as equity funds yet will never have a potential return like equity. So again, take a look of your bond funds or balance funds half yearly financial statement. Check it out.

But bond would rank in priority over the claims of equity shareholders in the case of insolvency, you argue. This argument is irrelevant for the purpose of investing due to two reasons:
  • We should never allow our investment to reach a stage that we have to depend on preferential ranking in respect of insolvency claims. We invest to earn, not invest to lose money and to claim back part of our principal. We can detect early sign of corporate distress by reading their financial statements.
  • When a company reach the stage of publicly known insolvency, we can rest assure that the company would have a huge debts level that whatever left, even for creditors and bond holders, are minimal.
The question of ranking in insolvency claims is therefore never relevant in the topic of investing for profit.

There will be more on investing in bonds...and don't expect favourable opinions. ;-)

Part 1: Buying bond funds? Read this
Part 2: Malaysian Bond Market
Part 3: Criteria of selecting bond funds

  • Risk(a) refers to price fluctuation that can be eliminated through longer term investing time span. Corporate bonds have lower risk(a) since their prices are less volatile. However, for long term investing, we can ignore risk(a).
  • Risk(t) refers to the possibility of incurring permanent loss. Corporate bonds risk(t), the possibility of permanent loss, are almost the same as the companies' shares.

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