A common misconception amongst investors is that bond funds are safe. Considering they are termed as fixed income investments investors assume that their income from the fund will be fixed and carries very low risk.
As wise man once said, there is no such thing as a free lunch. This applies to the world of investments as well. Risks are inherent in any kind of investments. It’s important for an investor to understand them and take calculated risks.
“Take calculated risks. That is quite different from being rash.” — General George Patton
So, how can an individual lose money in a bond fund? What kind of risks are they prone to?
To understand the risks, you first need to understand how individual bonds work?
Let’s understand this with an example
When you buy a bond, you are effectively loaning money to the issuer of the bond (be it a company or the government). Let's assume Tata Motors issues a bond in the market paying an interest rate of 7% for 10 years.
When you buy that said bond you are loaning your money to Tata Motors. The loan will last for 10 years, over which Tata will pay you a fixed amount of interest money (@7%).
At the end of 10 years you get your entire loaned amount back.
Now, this entails two risks:
1.Tata Motors capability to re-pay the loan amount after 10 years - Credit Risk
2.The movement of interest rates in the market over the next 10 years- Interest Rate risk.
But why should market interest rates affect your Tata Motors bond price?
Bond prices and interest rate are inversely related. They move in opposite directions. So, if interest rates rise, Bond prices will fall and vice-versa.
Assume that after this interest rates increase and Infosys issues a bond paying an interest rate of 9% for 10 years. You would naturally want to buy this and get rid of the Tata Motors bond. But why would anyone buy your Tata Motors bond with the low paying interest rate? You will have to entice the buyer by offering your Tata Motors bond at a discount and incur a loss.
A Bond does not lose its value unless it is sold before its maturity
Now if you were an individual investor with a single Tata Motors bond you might just ignore other bond issues and sit tight with your one bond until its maturity. You only have a notional loss, not an actual one.
But a mutual fund doesn't do that. They are assessed by their Net Asset Values which are now marked to market at the end of the day. So, in a rising interest rate environment, where bond prices have fallen the Bond Fund's NAVs are usually affected adversely and have been adjusted for the same.
Co-relation between interest rates and Bond maturities
A Bond Mutual Fund will perform better when the interest rates are falling. To determine how dramatic the fall or rise is depends on the maturity of the funds. The longer the maturity the greater the sensitivity to interest rates.
When interest rates rise and bond prices fall, the long term bond funds will decline more in value than the short term funds. Similarly, when interest rate decline and bond prices rise, long term maturity bonds should perform better than short term funds.
Falling interest rates work better for a bond fund.
Credit and liquidity risks are also a serious concern when it comes to investing in Bond Mutual Funds
Bond funds or mutual funds in general usually alleviate that via diversification. But there are cases that have wiped out an entire years returns (IL&FS defaulting affected several bond mutual funds). Amtek Auto defaulting almost wiped out 23% of one of the largest fund houses in the country - Franklin Templeton Asset Management.
Even though SEBI has taken steps to address these issues and implemented 'side pocketing' with an aim to protect investors from bad credit rating leading to illiquid assets, these concerns continue to persist.
Sure, Bond funds carry a lot less risk than Equity mutual funds do. And that is probably evident by the kind of returns they generate. But it is always wise to examine and develop a deep understanding of all risks of an asset class before exposing your hard earned money to them.