What Type Of Account Is Additional Paid-In Capital Treasury Stock Know Your Investment Risk in Bond Mutual Fund

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Know Your Investment Risk in Bond Mutual Fund

A fixed income mutual fund is touted as the safest asset class in an investment fund. But is it as safe as a term deposit?

The answer is NO.

A term deposit is a risk-free investment tool that guarantees you a return. A fixed income fund does not.

So what is the financial work behind a fixed income mutual fund?

A fixed income fund invests in bonds. In this article, the terms fixed income fund and bond fund will be used interchangeably.

Bond

A bond is a fixed income security. When issued by the private sector, it is known as a corporate bond. Considered a debt instrument to raise capital to finance expenses or working capital without diluting ownership rights (unlike equity).

From the investors’ point of view, they will lend a sum of money to the bond issuer, and in return they will receive a predetermined rate of return (coupon payment, usually between 5 and 10 percent) on their capital annually/semi-annually/quarterly. In addition to this, capital will be paid to the investor when the bond “mature”, usually within 1 year for short-term bonds (such as Treasury bills) and 10 years for long-term bonds. The initial principal amount can be less or more than the final principal payment, the former is known as a discount bond and the latter as a premium bond. In short, the investor is guaranteed to receive compensation in the form of a periodic coupon payment in addition to the value of the bond’s “price” discount.

Systematic risk

Systematic risk is the investment risk associated with local and global economic conditions. This is, more often than not, the main risk for government bonds.

The net asset value (NAV) of a bond fund, which consists primarily of a portfolio of government bonds, fluctuates with the economy. This type of risk is something that no one can control, but is perhaps more predictable. You will know that an economic downturn is on the horizon if you are aware of many economic indicators, such as the interest rate, the purchasing managers’ index, and the business conditions index.

Government bonds are almost like a risk-free investment, unless you live in a country like Greece, where the government could default on its country’s debt. The United States, for example, has a three-times sterling bond rating until it is downgraded this year.

Unsystematic risk

A more unpredictable risk inherent in a bond fund is unsystematic risk. This type of risk is associated with the entity or corporation that issues the bond. This is more likely for a company, regardless of size, if the company is poorly managed. His analogy is this. I save a sum of money from my family members and buy a mortgage from you. You are the corporation that issues me the bonds, and I am the mutual fund, while my family members are the bondholders (investors). You take money to gamble and end up losing everything. As a result, you cannot refund me either the principal or the periodic coupon payment. The fund goes down the drain with investors’ money if the bond issuer defaults on its financial obligations.

How to reduce risk

Whichever bond fund you choose to invest in, take the time to read their financial statements twice a year. One is an annual report issued after the end of the financial year of the fund, the other is an interim report. This may sound tedious if you are not a financier; but trust me, this is something you can do in 30 minutes. You probably spend more time planning your vacation, so why not spend some of that time flipping through annual reports when your money is at stake?

Focus on bond funds. See if the foundation’s goals and mandate have changed. A mandate may mean the lowest class of bonds that a fund manager can hold or buy for the fund. Any bond has its own rating, which reflects the creditworthiness of the issuer of the bond. In layman’s terms, the higher the rating, the less likely a bond issue will default. The rating is evaluated independently by an agency such as Standard & Poor’s. Make sure all bonds held in the fund are investment grade (BBB and above). Any bond below this grade is considered a junk bond and should be a red flag. Redeem your money and look for other funds instead. Don’t risk your money in junk bonds that may promise higher returns.

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