Is the choice between bond funds and term deposits (TD) a choice between apples and oranges? On the surface, it’s understandable if many investors see them as quite different.
Bond funds are a more complicated investment choice, but when you look closely at the investment outcomes that each gives you, it’s more accurate to say that they are different kinds of apples, rather than different kinds of fruit. In the end both bond funds and TDs deliver returns that come from income.
When someone invests in a TD they outlay a specific amount, and they can see on-line that their investment is always ‘worth’ that amount, which they’ll get back at maturity. They also know the interest they’ll get. For example, a $100,000 investment in a 3 year, 4% TD becomes $104,000 in a year’s time and $112,486 (with compounding) in 3 years’ time.
Compare this with the way the unit price of a bond fund changes daily, and how there’s no certainty about the capital value at any point in the future; compare the predictable interest income of a TD with the way a bond fund’s income distributions change from year to year. And this all happens without the same upfront indication of the interest rate that you get with a TD.
Investments that mature
Bond funds don’t mature. To get capital back, an investor has to redeem units. However, bond funds hold securities that mature, just like TD’s. In Australia, funds hold government bonds that tend to have an average maturity profile of around 4-6 years, while corporate bonds typically have around 2–4 years average maturity. Comparing bond funds with TD’s of these sorts of maturities allows for an appropriate comparison.
Although bond funds invest in securities that have to be repriced daily, which flows into a changing unit price, the nature of fixed interest is that none of the price changes are permanent. Every bond whose price has risen above par (100 cents in the dollar) will eventually mature at par (assuming no defaults); and every bond marked at less than 100 cents will eventually rise back to par value at maturity.
This means that over time, the capital value of a bond fund investment (encapsulated in its unit price) will tend to revert to its long run average. All capital gains are either realised (and thus boost income) or evaporate once the bonds approach maturity, and all capital losses eventually are made up as bonds amortise to par.
No one would look at the 3 year TD example above after just one year and say, ‘this isn’t worth $112,486, it’s let me down’. Neither should an investor look at a bond fund after 1 year, which is too short a time to let its dominant feature – its interest earning capacity – come through.
Returns come from interest income
It may surprise some people, but the return from investing in bond funds does in fact come from the interest income they earn. When you look at a bond fund’s returns over periods of 3 years or more, shorter term volatility largely evens out. Over the medium term, fund returns are dominated by interest income. To see this, look at the split between the ‘distribution return’ and the ‘growth return’ that fund managers report. The longer the time period, the smaller is the growth component for bond funds.
A bond fund investor can’t be told exactly what their interest payments will be, because a unit trust doesn’t have static holdings. The exact flow of interest payments is harder to predict. But investors can be told the yield being earned by the fund at a point in time, which is comparable with the interest rate on a TD.
The most useful yield measure is the weighted average yield to maturity of each bond in the portfolio. Strictly speaking, only individual bonds have a ‘yield to maturity’. To say that the yield to maturity of a bond is X%, is to say that every future cash flow – the interest payments and the repayment of par at maturity – is priced to deliver a return of X% pa.
Because funds don’t have a maturity date, they don’t have a yield ‘to maturity’. But the average of the yields of the individual bonds in the fund can be calculated, and it provides a similar indication of the future return. It might be higher or lower in any one year, but over 3 to 5 years - no matter whether market yields rise or fall after the investment is made - the annualised return will end up close to the initial average yield.
This information can then be used to assess the relative attractiveness of a TD or a bond fund for meeting your investment needs. It’s not all that the investor needs to know, but is an important piece of the puzzle. Unfortunately, most fund managers don’t routinely provide investors with yield data on managed fixed interest funds. Investors wanting to compare the manager’s products with TDs should ask them for the information.
A significant implication
Many investors are concerned that if they buy into a bond fund and yields in the market rise significantly, then they will lose their capital. They would rather buy a TD which seems ‘safer’.
Formally, it’s true that TDs don’t fall in value. But if you invested $100,000 in a 4 year TD at a rate of 4%, and soon after the same bank offered a 4 year TD at a rate of 7%, then you have missed out on $3,000 a year of extra income. You will still get $100,000 back at maturity, but the economic reality is that your investment isn’t as valuable as the new TD now available. (Vice versa if you invested in the TD at 7% and then saw rates fall to 4% - you’d be over the moon, but the bank wouldn’t tell you that the TD was worth any more than your initial outlay.)
With bonds, these disappointment or ‘over the moon’ factors are made explicit in the price, and the unit price of bond funds.
So, what happens if you invest $100,000 in a bond fund with an average maturity of 4 years that is yielding 4%, but soon after market yields rise to 7%? You will see a fall in the unit price of about 10% and your investment falls in value to about $90,000. But if your time horizon is 4 years and if you don’t redeem, then the mark to market loss isn’t realised. Just as with the TD, you will keep being paid a distribution as the bonds keep paying interest. And as the bonds in the fund gradually appreciate in value back to their par values, the unit price will gradually recover to reflect that reality. (These comments leave aside any active decisions by the fund manager, which could either help or hinder the outcome.)
In addition, in a bond fund which has securities that will mature during the course of the next 4 years, those will be reinvested at the higher yield and start to earn 7% for the fund. Thus, in 4 years’ time you can still expect your investment to be worth $100,000, plus the fund’s distributions will amount to a bit more than 4%.
If you believed that the rise in yields was going to happen you wouldn’t do either – you wouldn’t lock in through the TD any more than you’d invest in the managed fund. The point being made here is simply that investment outcomes between TDs and bond funds are actually similar. In neither case does a sharp rise in yields mean the investor has permanently lost their capital.
Both term deposits and managed bond funds can play a role for investors who want relative capital security and reliability of income. Despite their obvious differences, they are really apples and apples rather than completely different types of investment.
Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management, and is now a consultant and writer on fixed interest, including for institutional magazine KangaNews.