Some bond funds are now forgoing safety in pursuit of higher yields. There are basically three warning signs that investors should be wary about.
The first is that if a fund starts to invest in bonds with a credit rating of CCC or lower, this category is regarded as bonds where things are not going that well. In a span of 30 years which ended a year ago in 2013, the average level of default for bonds with those credit rating was 12.9 % while typical yield was 15.5 %.
A yield does not hardly compensate the investor for the elevated risk for being in default. Funds which invest in CCC or lower rated bonds are measuring the depths of the market in search of the yield.
By way of contrast, the bonds with a credit rating of ‘BBB’ which are regarded as investment grade, have a default rate in the same timeframe of just 0.1 % and a yield of 3.9 %.
The second consideration for investors evaluating their bond fund is whether it is invested in catastrophe bonds. These bonds which effectively provide for insurance companies to sell the risk are facing the calamity head on such as natural disasters and similar others.
While for the first time, some bond funds in Britain have been placing money in and it is of course very hard to know what the level of risk there is. Certainly it is very difficult for a private investor to know that.
The final concern investors should be mindful of is whether their bond funds are actually investing in some of the newer types of bonds which are issued by the banks. These bonds are often referred to as hybrid bonds.
Some of these bonds can be converted by the issuer into equity which basically is not really that bad because investors get something back when things go horribly wrong, but there are others that can be written down which means that the investor does not receive anything back.
In a situation where in one is unsure of the stakes, it is best for private investors to stick with relatively small bond funds. When they have a small amount of winners, and a small amount of losers they can opt to pursue one of the two strategies.
The first is to try avoiding the losers and that is alright for bigger bond funds since they have so many of the index tracking type of bonds that basically manage in avoiding the losers so that they can outperform the competition by virtue of compounding.
The primary consideration to remember is that avoiding the loser results in the bond ending up 0.1 % in the market and avoiding that means that the index requires it to be at least 0.1 %.
When traders pursue this type of strategy, it is sort of a high conviction approach and that if they buy bonds that outperform the weaker ones, they can best the bigger funds that way. However, a smaller fund will not necessarily surpass it by simply trying to avoid the losers along the way.
An approach of veering away from the losers and buying the 85 %-90 % of bonds that mainly track the index works for larger funds and a strategy of trying to pick the winners which pays lesser attention to bonds that follow the index is a better option for a smaller fund.
Recently the holdings in emerging market bonds have been constantly on the rise. The spread us now at near similar levels to what it was back in 2009, but in the recent sell-off, the good bonds have been sold off with the bad and that is indicative of a limited opportunity.