You may have noticed that bond funds or fixed funds NAV has been declining for the past few years. This is because interest rates in the US have been increasing since 2016. Other countries usually follow the interest rate pattern of the US, which includes the Philippines. We have a question from our FB follower which states:
Thank you for spreading financial literacy through your blogs and through your seminars. I really loved your seminar especially the one on stock market fundamental analysis. It was indeed eye opening, yet very easy to understand and digest.
Anyways, my question is that recently I have noticed that my fixed income fund investments have been going down. I was told that fixed income funds are very stable and are not volatile. If that is the case, then why is the NAV of my fixed income fund down?
Thank you for answering my question in advance and more power to you FinancePH. Keep spreading financial literacy as more and more people are empowered to be more financially literate.
Hi Kris, thank you for your kind words. First I would like to thank you for asking this question as it will clarify issues on the fixed income fund as being safe and not volatile. Yes, it is true that the fixed income fund is safer and less volatile than stocks but it does not mean that it is not prone to market price fluctuations. The person offering to you the bond may have told you that it has lesser risk but failed to inform you about the interest rate sensitivity of fixed income funds and bonds. This is because the concept of bonds and interest rates are quite difficult to explain especially to new investors. Still it is important to know why fixed income fund NAV (Net Asset Value or Unit Price) goes up and down in relation to interest rates.
Fixed income funds or bond funds are being managed by fund managers. They have the mandate to buy or sell bonds to help the investors of the fund earn decent returns averaging 1% to 8% per year. Fixed income funds increase in NAV in two ways. One is through the interest payments received from the bonds that are inside the fund. And the second is through the market value of the bonds inside the fund.
Say a you bought a P1,000 peso bond giving 4% interest rate last 2008. For the purposes of discussion it has a 20 year maturity, which means it will give 4% of P1,000 for 20 years or P40 per year until 2028. At 2028, you will receive back your P1,000 bond if you SURRENDERED your bond at MATURITY DATE (2028).
Now for example during 2018, you needed money and cannot wait till 2028 to receive your P1,000. back You decided to sell your bond. The price you can sell your bond will be dependent on what is the current prevailing interest rate for new bonds being sold in the market at the time of selling your bond.
If the new bonds in the market are giving more than 4% interest rate, then you cannot be able to sell your P1,000 bond for P1,000. To encourage investors to buy your bond giving 4% interest rate you must sell it at a DISCOUNT (lesser than P1,000 because new investors buying new bonds will give them an interest rate higher than 4%, so you must make your bond attractive to investors by selling the bond at less than P1,000 for example at P950 instead).
The opposite is also true, if interest rates are declining, the bond prices will go up. In the example if interest rates of new bonds are at less than 4%, then if you want to sell your bond, many people would want to buy it because it gives 4% interest. New bonds gives more less than 4%. Thus, you can sell your bond at a PREMIUM.
The effect of interest rates are usually medium to short term and are not long term. It usually depends on how long the durations of the bonds are in the fixed income fund that you bought. If the fund manager of the fixed income fund is holding short term bonds (bonds with less than 5 year maturity), then the effects of changing interest rates will not be significant. If interest rates are going up, the fund manager can be able to surrender the bonds he bought after 5 years and buy new bonds. In this case, the new bonds bought will have higher interest rates (since interest rates are going up) and the fixed income fund will have higher returns (since the fund manager bought bonds with higher interest rates).
The market value of the bonds fluctuate in the short term. But the bond prices always go back to its original price when surrendered. For example a bond initially issued at P1,000 may go up or down in price depending on the interest rates of new bonds in the market. However, by the time the bond matures (say after 20 years or 5 years), the bond holder will always receive what he initially paid which is P1,000. This is of course on the assumption that the bond buyer held the bond until maturity and did not sell it before the end of the maturity date.
I hope I was able to shed light on why bond prices go up and down in relation to interest rates.
Mark Joseph T. Fernandez, CPA, RFC, AFA, AWP, AEP
Head Financial Advisor
FinancePH Financial Advisors