You always considered Bond Funds as safe or risk-free investment. Bond Funds operate in the Debt Market. They primarily buy and sell government, semi-government and bank-backed bonds which may be considered as safe. But, don’t be surprised, bond funds are not!
Bond Funds have elements of risk associated with them despite investing in so-called, Risk-Free Investments. Before delving deeper into how Bond Funds are risky, let us understand what Risk-Free Investment means.
Government securities are often referred to as risk-free, in that the security of the capital over the time of the investment is assured, that is, interest payments will be received on a regular basis and the face value of the security will be received at maturity. The chance of a major government defaulting on repayment is minimal. These securities are therefore used as a basis for determining a risk-free rate of return in an economy at a certain time.
Since, portfolio of a Bond Fund consists of Government Securities, they are deemed to be safe. However, these funds are subjected to Interest Rate Risk and their Net Asset Value (NAV) fluctuates based on the changes in the prevailing interest rates.
Impact of Interest Rate changes on Bond Funds
While bond funds are supposed to be a stable investment, their NAVs can and do fluctuate in reaction to interest rate changes and other events affecting debt markets. The reason for this is – when interest rates change, they affect the prices of the bonds that make up the bond fund. Therefore, to understand the impact of interest rates on bond funds, you need to understand the impact such changes have on bond prices.
It has been observed that bond prices and interest rates have an inverse relationship. That is, when interest rates go down, bond prices go up and vice versa. Further, the impact of interest rate changes on prices is more pronounced in the case of longer duration bonds.
Thus, for bond funds, the implications are clear. When the interest rates go up, be prepared for a drop in the NAV due to the bond prices going down. However, fresh investments made by the fund will then be made in instruments that yield more. The reverse will happen when interest rates fall. While the bond fund will record a gain in NAV, on account of the appreciation in the value of the underlying instruments ie. the bonds, subsequent investments will be made in instruments of lower yield.
Added to this is the maturity profile of the fund. If a fund is locked in debt instruments of longer durations, then the impact of such changes would be greater on the overall portfolio. Therefore, while investing in a bond fund in a volatile interest rate scenario, be sure to look at the what type of securities the portfolio comprises of, along with other related factors.
While direct investments in Government Securities guarantee you safety of your capital and interest income at the specified rate of interest, investment in a bond fund does not offer you safety on both these terms.