Analysis of International Bond Fund - Essay Example

The worlds capital markets enjoy unprecedented breadth and strength, according to a research conducted by the McKinsey Global Institute (MGI). The global financial assets total more than $118 trillion and will exceed $200 trillion by 2010 if current trends persist (Farrell, Marcheva Key & Shavers, 2005). The financial markets are becoming deeper and more liquid, which provide better access to capital and improve the allocation of risk. The growth in the global financial assets comes from expansion of corporate and government debt and it encompasses all the benefits and the risks. Bonds are one of the methods of raising capital by the issuer, apart from selling shares or taking a bank loan. Once issued, the bonds too can be traded in the open market like shares. Bonds, like other debts, can be structured in different ways. Bonds attract interest and the yield from the bond is the interest rate paid on the bond divided by the bond’s market price. Bonds are normally treated as low risk securities, specially the Government Bonds. Corporate bonds by blue-chip companies are also considered safe. Nevertheless, bonds are rarely risk free. There are various risks associated with bonds and can have far reaching impacts. The income from bond is usually fixed but interest rate fluctuations affect the capital value of investments. The yield and hence the market price always depends on the market environment. A bond investor would normally avoid investing in overvalued bonds where the risk of default far outweighs the extra yield. If a bond portfolio is well structured it would be diversified across a range of credits with no concentration in undue sectors or issuers. Even the highly rated bonds carry certain amount of risks. Bond may be called or redeemed before the maturity date. Poor management of the organization by the issuer may reduce or even destroy the value of the bond. If a company is doing very well and has surplus cash to pay the outstanding debts, they may call the bonds. They would result in lower rate of interest for the investor. The issuer may call back this bond and issue fresh bond with a lower rate of interest. Hence, if the bond has been called, there would be no interest paid on such bonds. Various economic risks affect the value of bonds. These include rate of interest and the inflation (Online, 2004). If a bond was issued before the interest rate increased, it will lose its vale if it is sold before the maturity date. This is because in such a situation its price is likely to be lower than par value. When the interest rates fluctuate, the bonds are at a risk and it is difficult to sell them because investors and traders look for bonds with high interest rate. This has a far-reaching impact on bonds as investors move away to shares. This further depresses the bond market and its value further reduces. Inflation can cause erosion of profits if the bond has a long maturity period. The buying power of the interest payments and principal is significantly reduced. While Government bonds are safer than the corporate bonds, if the bond issuer encounters financial difficulties, the value of the bond could fall rapidly or become worthless. Other unforeseeable risks include downgrading in rating by an authority. This is known as creating a "fallen angel". The value of the bond falls when the issue receives reduced credit rating of the issuer. Rating is issued after monitoring the bond issuer’s financial conditions and if downgrading does occur, investors demand a higher yield, which consequently causes a fall in the price of bonds in the secondary market. On the other hand, increase in credit rating could lead to capital appreciation. The higher the rate of interest on any bond, the higher the perceived credit risk of the issuer (Aberdeen, n.d.). The greatest threat that bonds pose is when the bond issuer defaults in payment of interest or repayment of the principal due to economic downturn. The impact of the default can be reduced by diversifying the portfolio across a wide spread of issuers and sectors. Economic growth prospects, inflation, the governments fiscal position, short-term interest rates, and international market comparisons determine the appropriate level of bond yields and consequently the bond prices. The fixed coupon payments and the final redemption proceeds from the bonds are all known at the time of purchase. This means the return from the bonds is fixed and if it is held until the redemption date, the total return achieved remains unaltered from the date of purchase. Nevertheless, at the time of purchase, it should be borne in mind that various economic factors influence the market environment. Therefore, if a bond is sold before the redemption date, there may be a difference in the return and it could result in either profit or loss over the period. The high yield bond funds are exposed to credit risk, which reflects the ability of the borrower to meet its obligations. This means the bond issuer should be in a position to pay regular interest and return the capital on redemption. If the quality of the issuer if high, he would pay a lower rate of interest to borrow from the market. Those having a lower quality tend to pay higher rate of interest (for the higher risks taken by the investor), hence the investor should be careful while investing. Investing in higher-yielding, lower-rated corporate bonds, commonly known as “junk bonds”, carry a greater risk of price fluctuation, apart from risk like loss of interest or the principal amount (AIM, 2006). Bonds that are rated below the investment grade are subject to greater risks than ‘investment grade’ debt securities. Such bonds are speculative as their issuers are vulnerable to financial setbacks and economic conditions than issuers with higher ratings (Van Eck, 2006). Emerging markets pose threat to investments. Such markets are more volatile than more mature markets and the value of investments could sharply move up or down. The registration and settling arrangements in emerging markets are less developed so the operational risks of investing are higher. Political risks and adverse economic conditions in an emerging market are higher, which puts the investment at higher risk. Discretion on the part of the investor is necessary to determine where the issuer (of the bond) is making the investments of the funds raised through the bonds. Funds invested in a small market sector are likely to be more volatile than diversified funds. Likewise, a specialist market sector may have trouble in realizing some of the underlying holdings. Similarly, country specific funds carry a greater risk due to their concentration in a particular country than funds, which are invested across different countries. Finally, small and medium sized companies carry greater risk than a more widely invested fund. Unlike equity, bonds do not carry a single exchange price or opening and closing price. There are several issues available in the market and a large number of such issues are not traded at all. Even if the bond issuers are willing to quote a price, research has revealed that almost 2000 such prices were stale, which means they had not been traded for over a day (Mariathasan, 2004). Prices indicate the fair value of securities in the absence of any other information. Bonds are rarely traded and hence credit rating is difficult. The index providers are faced with the choice of coverage versus investability/liquidity. Liquid indices are attractive but the bond fund manager’s performance has to be measured against the risks controlled relative to the market. Standard Life Investments UK (2006) reports that yields from bonds were very low until recently. The reasons associated were limited government and corporate issuance, due to which there were no index-linked and longer-dated bonds available for investing the pension funds. Corporate bond funds are often considered to be a "half way house" between equity funds and building society accounts. Capital here is not secure and investment is not risk-free. There are always risks associated with investments in funds containing investments, which are below investment grade. Hence, such investments pose a greater risk than investments in equity funds. Thus, an investor’s portfolio should not contain only investments in bonds. The longer the maturity period of the bond is, the higher the risk of price fluctuations due to changes in interest rates. An investor should take into account the capability of the company to meet both the capital and income obligations of its bonds on the due dates. Past performance of any company is not indication of future performance as the market environment keeps changing. Investment in bonds can result in losses depending on various factors discussed above. They could even become valueless. The only advantage is that in case of liquidation of a company, bondholder’s get preference over the shareholders as bonds are debts. Nevertheless, however secure investments in bonds may be, they do carry certain risks. References: Aberdeen (n.d.), Risk Warning, 10 June 2006 AIM (2006) International Bond Fund, 10 June 2006 Farrell D, Marcheva Key A, & Shavers T (2005), Mapping the Global Capital Markets, 10 June 2006 Mariathasan J (2004), Bond indices: understanding all the angles, Balance Sheet Volume 12 Number 4 2004 pp. 10-13 Online (2004), Online Stock Trading Guide, Bonds Investment Risks, 10 June 2006 Standard Life Investments UK (2006), Improving Investor Confidence, 10 June 2006 Van Eck Global (2006), Worldwide Insurance Trust Funds, 10 June 2006 Read More