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Bond funds and term deposits are apples and apples

 

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.

 

 

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4 Comments

Warren Bird

March 20, 2013

Thanks John, what you say is technically correct. In my remark about active managers possibly helping or hindering, I could also have said 'leaving aside the actions of other unit holders'.

If that were to happen then the forced realisation of capital losses would be an offset to the income earned by interest payments. It would reduce the distributions paid by the fund, but doesn't change the total return. The total return comes from interest payments, realised gains or losses and unrealised gains or losses. The mix of the realised and unrealised is changed, but not their total size.

So, if there were no selling by unit holders then there would be higher distributions than in the scenario you described, but more unrealised losses.

Another point I think needs to be understood, though, is that your scenario assumes that the forced selling will realise losses. It needn't happen that way. If the bonds in the fund are well seasoned – that is, they were bought for the fund some time ago at higher yields - then the forced selling could in fact force some gains to be realised. This is a reasonable possibility in a lot of funds after a fall in yields of the extent we've had in the last year or two, which means that there are a lot of unrealised gains still sitting in many of the bonds in the market.

Every fund is likely to be in a different situation. One possibility is that an active manager may have already realised those gains, by selling bonds to reduce the term risk in their portfolios. But since that is a defensive strategy, the rise in yields that you fear would not have a significant detrimental impact on the fund’s unit price or return.

Another possibility is that the fund manager has already realised a lot of gains to boost the distribution payments above their interest earnings. This strategy means that the fund will distribute more in line with the high total return that the fall in yields has generated. The fund may not be defensively positioned for a rise in yields as the term risk strategy doesn’t have to be shortened by this – it involves selling long bonds but buying other long bonds in their place. The disadvantage of that strategy for investors is that it leaves no buffer for the scenario you have in mind. This happened with many funds back in 1992 and 1993, and may be the reason for your belief.

Index bond funds should be sitting on unrealised gains as they won't have traded securities in the portfolio.

Can you find out what the manager has been doing? Yes. The history of a fund's income distribution rate will reveal if that has happened or not.

One other point is that an investor in a fund has the option to get out if they believe the bear market has further to run. A TD holder doesn't have that option. I think I know what you mean by saying that with a TD you have more "control" - you aren't dictated to by the actions of others. However, with a TD you have ceded your control over redemption timing and level to the bank. They will charge a penalty fee for early exit, which may be a lot larger than the capital loss you’d realise by exiting a fund.

That's not an argument for or against TDs vs funds, but just a reality that investors need to take into account in weighing up the options.

Warren Bird

March 20, 2013

Hi Lorraine,

yes, you need to take the fees into account. These should be deducted from the fund's gross yield to get the return estimate that the investor can compare with TD rates.

For example, the yield on the most commonly used bond index in Australia, the UBS Composite All Maturities, is 3.6% at the moment. An investor in a fund that manages to this index might pay their manager around 0.5% for the wholesale version of that fund. So the net yield to the investor is 3.1%. That means that, if yields stay steady for 4 or 5 years (a big if, as I'm sure you know), the return will be around 3.1% if it's an index fund. If it's an active fund, then hopefully it will be a bit higher due to the value the manager adds from their active strategies. (If you didn't expect them to add value, I presume you wouldn't be invested with them.)

I've seen 4 and 5 year TDs at some banks at the moment paying around 4.5%. So on the basis of investing for a 4 or 5 year period, I leave you to judge what's more attractive.

The UBS Composite is mostly Commonwealth Government and Semi-government (State) securities, which typically pay the lowest yields in the market. Other funds with a different strategy, such as having a diversified corporate bond exposure, could offer a more competitive yield to TDs at the moment. Longer dated corporate bond yields are around 5.0 - 5.5% at present, for instance.

Also, the comparison could change - eg the banks could cut their TD rates, or market yields could move higher. For most of the last 20 year or so, typical bond funds have been more competitive than at present, but the banks are still relatively aggressive in their TD rate setting.

I hope that answers your question. Thanks for reading the article.

Lorraine Roberts

March 19, 2013

Hi Warren
I found your article very interesting,I did wonder if rates stayed flat at 4% throughout the 4 yrs (I know an unlikely occurrence) how would the comparison look then? For example are there any costs associated with a Bond Fund versus a TD? (ie annual management fees)

thank you

John Kay

March 15, 2013

Hi Warren,
Very interesting article, however I believe that if you are in a Bond Fund and yields rise when we get inflation there will be a rush for the exits as unit values drop and the fund manager has to sell at a loss rather than hold the bonds to maturity. With a TD the punter has a bit more control.


 

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