In my previous article, A journey through the life of a fixed rate bond , I provided an overview of the price and performance history of the Commonwealth Government Security that matured this month, April 2015. This article responds to a reader question about the similarities and differences between investing directly in bonds and buying units in a bond fund or Exchange Traded Fund (ETF).
What happens to the cash on maturity of the bond?
The first difference is that the maturity of a single bond doesn’t bring the life of a bond fund to a close. Other bonds with different maturity dates continue to generate investment returns.
Furthermore, within funds the cash that’s generated when an individual bond matures is reinvested into the market. Although unit trusts are required to pay all interest earnings and realised capital gains to the unit holders as distributions, the proceeds of bond maturities don’t have to be returned to the investors. Instead, they are used to buy new bonds in accordance with the investment policy of the fund.
This isn’t as big a difference as it might first seem, because it’s what direct bond holders often do in practice. Just as people who have a maturing term deposit then roll the proceeds into a new term deposit, so bond investors typically aren’t in the bond market for the limited period of the life of the first bond they invest in. They reinvest into the market and keep their bond portfolio going.
If an investor in a bond fund wants to get some capital back they need to redeem units. Otherwise the manager of the fund will automatically reinvest.
Behaviour of other unitholders
Another difference between owning bonds directly and investing in a fund is that the behaviour of other unitholders can impact some aspects of your investment.
When you own your own portfolio of bonds, you earn interest and only generate any capital gains or losses if you decide to sell some bonds before maturity. If someone else decides to redeem units in a trust in which you are invested, then that may force the manager to sell a bond before it matures. This could generate a capital gain or loss on that security.
This impacts the distributable income that all unit holders in the fund are paid. The main impact is that in addition to interest earnings there will be net realised gains included in all distributions. In turn, this can have tax implications, depending on the tax rate you pay on different sources of income.
There is also the possibility that the bond that has to be sold to fund the other unit holder’s redemption will be sold at a price that is different to the price used in valuing the fund. This could dilute the value of the fund for all unit holders, who have effectively had a small portion of their investment sold at a low price. However, this is usually managed by the fund having a buy-sell spread for transactions in units, based upon the market level of buy-sell spreads for the assets held in the fund. Therefore, it’s only the unit holder who redeems from the fund who experiences losses from this source.
Price movements of bond funds and ETFs
In the article about the April 2015 bond, its price history was summarised. There were times when bonds were in great demand and the price rose compared with times when bonds were unpopular and the price fell. Bond funds will similarly experience rising and falling prices through time, as the price of all securities held within the fund will change as market yields change.
However, a bond fund can be thought of as a family, made up of old bonds, middle aged securities and young ‘uns. That is, it holds a range of securities with a range of different maturity dates. Some will behave like the April 2015 did in its early days – highly sensitive to market yield changes and thus volatile in price. Others will be closer to maturity and behave like the April 2015 has done in the last couple of years – less volatile, with the amortisation towards par value being the dominant feature. A bond fund’s price fluctuations will reflect the average of all the individual bonds that are held within it.
In Australia, most funds have an average term to maturity of around 3 – 5 years. So they’ll fluctuate like an individual bond with 3 – 5 years to maturity. They will do this all the time, though, rather than eventually shortening towards zero. The reinvestment of maturing bonds across the market keeps the average maturity reasonably steady.
Government bond funds tend to be longer than the average – and thus more volatile in the short term - while corporate bond funds typically have a shorter average term and are less volatile.
Some of these features of bond funds also apply to ETFs, particularly the reinvestment of maturity proceeds and the way they tend to have similar maturity profile over time. One key difference is that the behaviour of other investors in the ETF doesn’t have the same impact because they don’t always force sales or purchases – another investor buys or sells units and the portfolio isn’t affected. Only when investor demand and supply for the ETF are out of balance will bonds have to be traded. This ensures that the value of the ETF reflects the market value of the bonds it holds, rather than the unique demand-supply conditions for the ETF itself.
Investing in a bond fund isn’t exactly the same as investing in individual bonds. However, the most important difference isn’t unique to bond funds. Unit trusts in all asset classes create the same exposure for an investor to the behaviour of other unit holders. For example, an equity fund investor can have the dividend and capital gain mix of their income influenced by other unit holder behaviour in the same way.
This article has been broad and general in nature, because specific bond funds have their own features – actively managed or indexed, for instance. It doesn’t cover all the similarities and differences, but hopefully does provide some helpful information about investing via funds compared with direct bond ownership. Some additional information can be found in another earlier article, The idiot's guide to bond funds.
Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing, including 16 years as Head of Fixed Interest at Colonial First State. He also serves as an Independent Member of the GESB Investment Committee. This article is general education and does not consider any investor’s personal circumstances.