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Understanding Fixed-Income Funds

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Fixed Income Funds broadly refer to those types of investment security that pay investors fixed interest or dividend payments until maturity date. At maturity, investors are repaid the principal amount they had invested.  Government and Corporate Bonds are the most common types of Fixed-Income products.

Unlike equities that may pay no cash flows to investors, or variable-income securities, where payments can change based on some underlying measure – such as short-term interest rates – the payments of a fixed income security are known in advance. In the event of company bankruptcy, fixed-income investors are often paid before common stockholders.

Fixed income investments are usually made as a hedge against drastic income volatility common with long-term investments such as equity investments. Risks are usually associated with long-term investment horizons as uncertainty trails long periods. Thus, the common safety shelter of reverting to fixed income funds is the contractual covenants that make the return look fixed and certain. A return on a 10% per annum 91 days treasury bill of N100 million is sure to return N2 .5 million less withholding tax and other processing charges.

In theory, this is so but not necessarily in practice.  The reasons range from trade off to risks that commonly alter expected returns on fixed income funds. They include the following:

  1. Monetary policies and interest rates: Interest rate is more often than not determined by fiat or induced by other economic environments and market conditions. Coupon rate (rate of return on fixed income fund) is inversely related to the interest rate. A crash in interest rate will mean higher coupon rate and higher return for fixed income investors. The contrary is the case when interest rates rise. This is interest rate risk.
  2. Coupon rate: This is another factor that affects returns on fixed income investments. The coupon rate of a bond depends on the rating of the issuer. Rating per se is not static. It fluctuates with existing variables either endogenous or exogenous to the issuing companies, institutions or a nation. Favourable rating means lower coupon rate and lower but certain earnings to the investors.
  3. Inflation risk: Inflation plays a vital role in the interest payment calculation for bond investors. Bonds ordinarily provide a fixed amount of income at regular intervals. Inflation results in the loss of purchasing power. Thus, fund income may no longer be fixed in fixed income funds.
  4. Credit risk: This is when bond issuers are not able to meet their repayment obligations and they default. The risk of issuer default is called credit risk. Generally, this risk increases with corporates that are not rated very highly by credit rating agencies.
  5. Liquidity risk: This is when you want to sell your fixed income security but cannot find a buyer as you are willing to sell the bond before its maturity. Usually, liquidity risk is higher in the case of bonds with a low credit rating.
  6. Duration risk: When you know the duration of a bond, you can assess the change in the price of a bond with the given change of interest rate.

Some of the mitigations against the enumerated risks are:

  1. Making the right choices to reduce risk and enhance returns. Invest only in highly rated bonds.
  2. Investing in target maturity funds: If you choose to invest in a target maturity debt fund till its maturity, then you can expect returns similar to what was mentioned at the time you invested in the fund (yield at the time of investment). However, the risk of inflation is not mitigated by this option.

By and large, fixed income securities can indeed become that umbrella that can protect your portfolio from fluctuations in fund income. However, you must be cognizant of the risks and accordingly make the right investment choices.

Source: DATA PRO

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