Saturday, February 18, 2006

Criteria of selecting bond funds

If you really need to buy bonds…

Are you above or at the age of 55? Last year, Bank Negara issued Merdeka Savings Bonds. The bond was sold directly to unemployed retirees through agent banks. Check the web site out and submit your questions online. I believe there will be similar issuance in the future to help the retiring community.

If you are not entitled to buy such Bank Negara bonds yet, you should consider the following factors before you buy into a bond fund.

1. Fund size
The fund size of a bond fund must be big enough to diversify risks. The smallest tradable unit of bond is RM5 million. A RM100 million fund can only buy up to maximum 20 bonds. Small funds are usually excluded from buying into many good bonds due to its limitation of size. Remember, buy bond funds with big fund size.

2. Composition of the investment.
Select those with highest proportion invested in bonds issued by government, Bank Negara or those corporate bonds rated as triple As (AAA). Investment in money market is ok. Just don’t touch those bond funds heavily invested in corporate bonds rated single A and below.

3. Track record of the fund management company. There are usually few names at the top of the bond funds table like Public Mutual, Prudential, etc. You will have to rely on their internal procedures in curbing the issue of professional integrity of fund managers.

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

Malaysian Bond Market

Malaysian bond market is still at its early developing stage. Liquidity of bond market is still an issue. There are not enough good bonds around for trading and there are not enough players around buying not-so-well-rated bonds at fair prices. There are several serious issues to buy into funds that invest heavily in bonds.

Good bonds in Malaysia, particularly those from government and Bank Negara or those with triple As (AAA) rating, are usually quickly snapped up by insurance companies for long term keeping. In a simplified scenario, if an insurance company has a claim rate or life insurance interest rate of 3%, it will use the funds from insurance buyers to buy government bonds that give interest return of 5%. As long as the insurance company keeps the bonds, it will earn 2%. Fund managers, usually, do not have such luxury of keeping most of its funds in bonds long term. There are bound to have unit trust investors withdraw their money invested in the funds. Fund managers can only cross their fingers and hope that the withdrawal will not be huge enough to trigger selling of bonds. In a case that they have to sell their not-so-well-rated bonds to meet the withdrawal obligation, they probably have to sell them at a lower price or not able to sell them at all. If they choose to sell good bonds, the funds were left with not-so-well-rated bonds.

Why don’t fund managers just buy good bonds? Because, again, they are not enough of good bonds traded around. It is a vicious cycle as long as our bond market is not big enough.

The above is the scenario that I understand a few years ago when I was in a team to establish a bond trading desk in the previous stockbroking firm that I was employed. (The project was scrapped later.) Several months ago, I had a conversation with an industry player. It seems things are quite still the same.

Unlike stocks, there isn’t a unifying board to show the market prices of bonds. Fund managers estimate bonds value by calling bankers for quotations. Such practice severely hampers the reliability of the published net assets value (NAV) and performance of the funds. How sure are you of the true value of the funds?

This leads to another issue. Bond funds investors rely heavily on the integrity of the fund managers. Without a unifying trading board and a pricing and trading mechanism like that in trading of stocks, what stop unscrupulous fund managers to have close door arrangements with bonds issuers or other interested parties for their own benefits in the expense of the funds? Most fund managers are honest folks, I reckon. But what stop the minority who are unscrupulous from benefiting, in the expense of our money invested in the bond funds?

I may be wrong, but I think investing in bond funds is simply full of landmines. It has simply too many unapparent variables.

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

Related site:
Looking for a complete and more balance view? Check this out at Asian Development Bank's web site.