1. Short Duration Bond Funds
What is a bond? According to Investopedia, a bond is a ‘fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments’.
Short-term bonds fall on the safer end of the debt securities risk spectrum due to their short duration and subsequent near-cash status. A shorter duration or maturity date leads to less credit risk and less interest rate risk.
As there are numerous bonds are out there with varying maturity and degrees of risk, investors can consider investing in short duration bond funds as they offer such advantages:
As with buying shares, it is important, from the standpoint of risk management, to diversify and not put all eggs in one basket. There are many issuers of bonds out there. A bond fund buys into numerous bonds (>100 in some cases), so there is a spreading of risk.
B. Ease of Management
One does not have to actively manage the bond portfolio, or manage redemptions, or switching of bonds.
C. Expertise knowledge of fund managers.
The bonds within the fund are selected by managers who understand the pricing, value and risks of the bonds, something which most retail investors lack. The selection is then regularly monitored so that investors may enjoy good returns and risk mitigation.
While the bonds within a fund have different maturity dates, an investor is able to buy and sell a bond fund on any given trading day. Liquidity, or the ability to convert an asset into cash, is assured.
E. Fewer restrictions on purchase
Many bonds are available only to institutional investors, or Accredited Investors, who may have to fork out $250,000 for a single issue. Bond funds remove such restrictions, and investors are able to participate in the bond market more easily.
What are the disadvantages?
A. Expenses and management costs
Funds are managed actively by professionals with the required expertise, and as such, there are management fees and expenses. However, even taking into account these and sales charges and advisory fees if applicable, bond fund returns can still outperform the low interest rates we see in the market.
B. No guarantee and bond prices may actually drop
Bonds, as with equities, do not afford investors any guarantee. By extension, bond funds do not guarantee investors a return, or the capital itself. During the severe market meltdown in March 2020, even the better performing short duration bond funds were not spared. However, their prices dropped by about 1.5%, which was far better than the bloodshed in equity markets (-30%). Bond fund prices have now recovered and delivered positive returns on a year-to-date basis.
Short duration bond funds may thus be suitable for retirees with low appetite, or pre-retirees who want to park their money in safe instruments which yield a return that can beat savings or fixed deposit accounts. They also suit those who place a premium on liquidity.