Bonds and Bond Mutual Fund - Assignment Example

Bonds and bond mutual fund Name: Lecturer: Course name: Course code: Date: Question 1 The logic behind the mutual fund’s claim in the advertisement The logic behind the claim made by the bond mutual fund in the advertisement will require a deeper understanding of the bond mutual funds. Sheffrin ( 2011, p.147) provides an understanding on how bond mutual fund operate, the classes of bonds that they deal with, the components of return, bond mutual fund yield and its determinants and treatment of capital gains of bond mutual funds is very important. Bond mutual funds Stein ( 2009,pp78-82) argues that bond mutual fund is an investment organization formed to deal with venture into portfolio comprising mainly of individual bonds. Investors buy the shares of these bond mutual funds. Each share held by the investors represents a proportional interest of ownership in the collection of bonds consisting of the portfolio of the bond mutual fund. How bond mutual fund work According to Sheffrin, (2011, p147) “highly competent professional fund managers use the investors’ money to buy and sell bonds for the investment portfolio which is compliant to the investment goal of the bond mutual fund”. By contributing their money, the shareholders of the mutual fund can invest a larger number and diversity relative to individual investment. A lot of bond mutual funds have least amounts of investments that are considerably lower than the principal amount of several individual bonds. For instance, only one Ginnie Mae bond may be worth $25,000 or even more, but an individual investor can put his investments in the majority of GNMA bond mutual funds with as low as $1,000. Classification of bonds that the bond mutual funds companies invest in Strumeyer, (2011 pp.50 – 63) gives his general view on classification of bonds in three ways that is, classified on the basis of the issuer, the period of maturity and the quality of the bonds. The bond mutual funds companies may choose to invest in either one or some mixture of these three types of bonds. Classification under the type of issuer The government of the United States trades its bonds through the treasury in order to raise money to fund the national debt and through different centralized agencies mainly for particular purposes. Also Strumeyer, (2011 pp.50 – 63) argues that local governments and states sell bonds in order to fund development plans, for example roads, schools, health facilities, airports and bridges. Business entities sell bonds to facilitate a range of reasons such as to fund new investments, or to purchase particular equipments. Classification under maturity According to Subramani, 2011, “maturity is the period of time taken for the principal amount of the bond to be repaid”. Generally, the maturity period of short term bonds is two years or less; medium term bonds takes between two and ten years to mature; and the long term bonds takes over ten years to mature. The interest rate risk is determined by the length of time a bond takes to mature and generally, if the period of maturity is long, then the interest rate risk is high. This implies that the holder will require higher returns because of the greater interest risk. Classification under the quality of the bond Bhat, 2009 views that, creditworthiness of the issuer determines the quality of the bond. Quality of the bond rests in the likelihood of the issuer to make periodic payments and the principal amount at the maturity date of the bond. The ratings of quality of bonds are done by independent rating companies and the information about these bonds is available in their websites and also in libraries. A lower rating signifies that the company’s bond is of poor quality meaning that the company has greater credit risk. Information on classification of bonds reveals that different bonds have different rates of return. The claim the bond mutual fund that they made a return of 13.5% over the last year might be true considering the classes of bonds they held. Components of the return of bond mutual funds The total return that is the return from the bond mutual fund investment is made of three components. Capital gains, fund’s yield and the changes in the value shares of the fund are the components of the total return. Institute of Investment Company, 2010 defines mutual fund’s yield as the interest received from the bonds that are held in the portfolio of the fund and are distributed as in form of dividends to shareholders. The fund’s yield is greatly affected by the quality of the bonds and maturity period. High yields are generated from bonds of lower quality and bonds that have longer maturity periods. Price depreciations can offset or surpass income generated. Prices of bonds held in the portfolio of the fund are subject to fluctuations due to diversity in the current interest rates and the creditworthiness of the issuer. Capital gains or losses are generated when the fund sell bonds whose prices have changed. Strumeyer, 2011 argues that fluctuations in the shares of the fund are the same as all mutual funds. To attain the real prices of all the securities, one must calculate the market values of these securities. When calculating the total return of a bond fund, changes in the prices of bonds held in the portfolio must be included along with any income generated from distributions of capital gains and dividends. The claims made by the bond fund in the advertisement might be true because the total yield of the bond mutual fund does only come from the interests but also capital gains and changes in share prices. Nikolai, (2008 pp.34 - 42) state that rates of return also vary depending on the maturity periods of the bond and also the quality of bonds held in a portfolio. Also most importantly, when the interest rates fall, the prices of bonds rises and vice versa. Question 3 The accounts for my father’s view of bonds and the rationale behind bonds Investment in either shares or bonds or any other kind of investment requires informed decisions. Investment in bonds might be less risky as compared to investment in bonds but the level of returns is always lower than stocks’ as argued by Sheffrin, (2011, p147). Investment in bonds is not 100% safe as claimed by my father. Investment advisors recommend investors to diversify their investment portfolio which is made up of bonds, cash and shares in different proportions, basing on individuals’ goals and situations. Risk tolerance and income needs will determine the composition of an individual’s portfolio. My father’s argument is only based on income advantage which to some extent is true. Nikolai, (2008 pp.34 - 42) argued that bonds tend to be more secure investments as compared to stocks. Bonds are a type of debt securities in that when one purchases a bond, he /she is basically lending funds to someone who promises to pay a fixed rate of interest and the principal amount when the bond matures. Bonds can be issued by governments, corporations or private issues. Bonds are traded just like stocks hence their prices are prone to change but volatility is not like in stocks prices. All bonds are faced with certain risks. The goodness is that my father is focusing on investing in U.S Treasury bonds which are the point of reference against which all other corporate and municipal bonds of USA are traded (Krishnamurti, 2009). This makes U.S Treasury the safest bonds available. The US Treasury bonds do not face default risk. The commitment of the US Treasury bears full faith and credit assurance of the government of USA that the principal amount plus the periodic interest will be paid promptly. Regardless of doubts of default by the treasury to pay interest and the principal amount of bonds, the US Treasury has powers to produce more money to pay off its obligations, as stipulated by Sheffrin, (2011, p147). The ability of the Treasury to print more notes is an advantage to Treasury bonds over other types of bonds for example corporate and municipal bonds. My father did not consider interest rate risk which affects all bonds despite of creditworthiness of the issuer. The value of bonds declines when the yield rates in the market increases. Nikolai, (2008 pp.34 - 42) describes that the period of bond maturity significantly affects the market prices of bonds because the market rates of yield are subject to fluctuations. If the maturity period is shorter, the changes in the price of the bond will be less affected by the interest rates. For example, a bond has a 5% coupon and the maturity period is thirty years and a note has a 5% coupon and its maturity period is 7 years. Assuming that all bonds were issued at US dollars 1000, and the market rate of yield increases to 8%, the value of the note will be $842 and the price of the bond will decline to $661. If the interest rates decline, the values of the bond and note will rise at same rate of increase. My father should consider bonds which have longer maturity periods when the interest rates are likely to fall for their prices will appreciate significantly as stated by Nikolai, (2008 pp.34 - 42) My father should take into account the liquidity risk and the general performance of the economy even if the treasury bonds have a better liquidity as compared to other bonds. He should go for long term bonds when the interest rates are low and he should sell them and go for short term maturity bonds when interest rates rise. Stein ( 2009,pp78-82) argues that bonds bears call risk. When a long term bond is valued during a period of high interest rates, it usually has a 5, 7, or 10 year call date. The implication if the interest rates are lower during call dates will be the bond will be called at a price that is already set in the prospectus or at par value. If he will be holding these called bonds, he will lose them and the principal amount is paid to him. My father’s conservative nature when making investments in bonds should also have in mind factors like interest rate risks and the amount that he will receive from his investments. It is true that US treasury bonds are less risky as compared to corporate and municipal bonds, but they are affected by the fluctuations in interest rates. The life span and the interest payments of bonds are fixed but the returns on bonds are not fixed. Reference List Bhat, S., 2009. Security Analysis & Portfolio Management. Excel Books India. Institute, I.C., 2010. Investment Company Institute. [Online] Available at: http://www.ici.org/faqs/faq/faqs_bond_funds [Accessed 6th June 2013]. Krishnamurti, C., 2009. Investment Management: A Modern Guide to Security Analysis and Stock Selection. Springer. Nikolai, L.A., 2008. Handbook Of Debt Securities And Interest Rate Derivatives. pp.34 - 42. Ninomiya, K., 2010. eHow. [Online] Available at: http://www.ehow.com/about_4775561_advantages-disadvantages-bonds.html [Accessed 6th June 2013]. Sheffrin, S.M., 2011. Financial Accounting: Accounting for Investment Securities. Wisley & Sons. p.147. Stein, P., 2009. Finacial Modelling:Dim Sum Bonds' on the Menu for Foreign Investors. Cengage Learning. Strumeyer, G., 2011. Investing in Fixed Income Securities: Understanding the Bond Market. Wiley & Sons. pp.50 - 143. Subramani, R.V., 2011. Accounting for Investments, Fixed Income Securities and Interest Rate Derivatives: A Practitioner's Handbook. John Wiley & Sons. Read More