For the affluent investor, putting a portfolio together to provide monthly income is not so much of a problem. People of more modest means still have the ability to provide that monthly income from bond funds. It is nevertheless important for the investor to realize the relationship between risk and return as the choices among bonds funds are quite wide and reflect that risk in the returns they provide.
Interest Rate Is a Statement of Risk – Period
To quote an age-old cliché, there is no such thing as a free lunch. If there is one simple concept that investors must realize about bonds or the fixed-income market, it is that interest rate is statement of risk. We know that risk can take many forms; market or yield curve, credit, foreign exchange and so forth. With that in mind, let’s take a look at what is available.
Money Market Funds
Money market funds are comprised of very short term debt instruments. Most of these instruments are very credit worthy and have little principal risk. While considered to be very safe from a principal risk perspective, the reinvestment risk is substantial and thus unpredictable and undependable.
The good news regarding mutual funds is that they are managed by professional asset managers. The bad news is that most mutual funds, regardless of the type of bonds in them, are also “open-ended.” What that means in practical terms is that as more money comes into the fund, it is invested at prevailing interest rates, whether those rates are higher or lower. This means that returns can vary constantly.
Unit Trusts, although related to mutual funds, are quite different. Regardless of the notes and bonds chosen by the professional managers, they never change. The notes and/or bonds in the trust may be sovereign debt, corporate debt or perhaps collateralized hybrid securities. The maturities are also different, coming in intermediate and/or longer term maturities. The major attraction of Unit Trusts is they usually pay a monthly check.
The choices are very wide both in terms of quality and maturity for the investor. Quality and risk are of course commensurate with return like anything else. Investors should be aware of the sovereign, credit and maturity risk before making a decision.
Costs and Fees
Another factor that investors should be aware of are the costs and fees associated with these products. Mutual funds can vary widely in terms of costs. Some are “no-load” or fee while others do have a “load” or sales charge. That fee can also depend on the amount of money invested. Read the fine print – some mutual funds charge a “management fee” in addition to the sales charge.
Unit Trusts are most always sold on a “net” basis. In other words, the dealer’s fee is built into the price, which the investor never sees. This fee is often 2% to 3% of the principal amount. A rule of thumb, the longer the maturity, the larger the fee. There is rarely if ever an on-going management fee however.
The bottom line for investors is to determine beforehand not only the risks involved but how much of their money is actually going to work for them.