These funds are interest-rate sensitive, meaning that if interest rates fall, the value of income fund shares may rise, and if interest rates are rising, the value of a bond fund share may fall. Many bonds in which mutual funds invest have no guarantees but they have traditionally provided higher current income than other fixed-income alternatives such as money market funds and certificates of deposit.
Portfolio managers constantly monitor the securities within the fund, buying and selling bonds to maintain or improve the fund's share value as they seek to achieve the best return that market conditions will allow. The share price of all mutual funds is calculated daily by dividing the total value of the securities held by the fund by the number of shares outstanding.
Maturity
Maturities are the length of time in which a bond must be paid. Bonds can have short, intermediate or long-term maturities. Short-term bonds mature in less than 2 years, intermediate-term bonds mature in 2 to 10 years, and long-term bonds have maturities of 10 to 30 years.
Generally, bonds with longer maturities pay higher interest rates to compensate investors for greater interest-rate risk. Longer-term bonds are more sensitive to interest rate movements than bonds with shorter maturities, causing longer-maturity investments to experience a greater degree of price volatility.
A bond fund's share price generally tends to fluctuate less than the price of an individual bond, however, due to the wide variety of maturities and individual characteristics of various bonds within a fund's portfolio.
Bond Prices
Investors are often concerned about the fluctuation of their bond fund's share price. Because of changes in the market price of the bonds held, the value of the bonds in a fund's portfolio changes daily.
The value of these bonds changes for a variety of reasons, primarily in response to the movement of interest rates. Bond prices and interest rates generally have an inverse relationship, moving up and down like a see-saw. When interest rates go down, the prices of bonds generally go up, and vice versa.
For example, a Rs.1,000 bond with a fixed annual rate of 7% and current interest rates fell to 5%, the 7% bond becomes more attractive to other investors, thus increasing its resale value. However, if current interest rates climb to 10%, the bond would be less attractive, causing its value to fall.
The prices of bonds are also affected by their credit quality and availability in the market. If there is an abundance of bonds paying a certain interest rate, demand may not meet supply, thus lowering prices. The reverse is also generally true. For example, as interest rates decline, people tend to look to corporate bonds for higher yields. Such increased demand can lead to increased prices in the corporate bond sector.
The price of a given bond also depends on its credit quality, which may change. However, despite the rating that bonds are assigned by the rating agencies, their value is continually changing. If a corporation with questionable credit strength restructures, the value of any outstanding bonds may increase.
Advantages of Income Funds
- Diversification. Income funds allow investors to spread their principal across a large number of securities, thus cushioning the effect that one bond can have on overall investment results. As market and economic conditions change, the portfolio managers can make adjustments in an attempt to meet the fund's stated objectives.
- Active management. Experienced portfolio managers closely monitor a mutual fund, buying and selling securities when necessary. This takes the burden off investors who may not have the time to do in-depth research about various investment possibilities.
- Affordability. Bond mutual funds can be purchased with an initial investment which is sometimes as low as Rs.1,000, and subsequent investments are as low as Rs.250. Individual bonds usually require a minimum investment of Rs. 5,000 and sometimes more, depending on the type of bond.
- Monthly income. For investors seeking a steady stream of income, bond mutual funds generally pay monthly dividends, whereas most individual bonds pay semi-annually. Interest payments from an individual bond are fixed; monthly dividends from a mutual fund will fluctuate with market conditions. A mutual fund pays fees to its manager, which does not apply to holders of individual bonds.
- Easy access to your money. Mutual funds allow investors to redeem shares at any time-at the current net asset value.
- No maturity date. Individual bonds eventually mature, leaving the investor with a lump-sum that must then be reinvested-possibly at a lower interest rate. Bond funds never mature-portfolio managers constantly roll the proceeds from maturing securities into new bonds. However, the share prices of mutual funds fluctuate with market conditions, and investors may have a gain or loss when shares are sold. Owners of individual bonds are generally paid their principal investment at maturity.