Previously, we have written about yields to maturity (YTM) (see Interpreting Yields for Bond Funds) representing the annualized returns on bonds. Since November 2008, we have been compiling YTM figures for various bond funds and have displayed them on our website so that investors can use the information to make decisions.  We have also mentioned in the article that as a general rule of thumb higher yields mean higher risk. In this article, we share with investors more information on how to assess the riskiness of bond funds.

Is the credit risk of your bond fund high?

Credit risk refers to the likelihood of the issuer not being able to repay the principal and coupon. Rating companies like Standard & Poor’s, Moody’s and Fitch ratings, issue and maintain credit ratings on the issuer’s bonds. The credit ratings aim to be forward looking in reflecting the default risk of the bonds. Table 1 shows the credit ratings by the three major rating agencies. The poorer-rated borrower offers a higher interest rate on their bond than the higher-rated borrower in order to compensate for a higher degree of default risk.

When an investor cannot recover the principal or coupon, the bond’s worth declines. So, if your bond fund has a majority of bonds with lower credit ratings, the credit risk is high because there is a higher chance of default on the bonds. The occurrence of default would reduce the value of the fund.

Duration measures interest rate risk

The bond price is inversely related to its YTM. If market interest rates go up, the YTM of the bond is likely to go up and the price of the bond would fall. For example, if interest rates rise from 2% to 4%, investors who want to sell their current bond holdings giving 2% coupon would have to accept a lower price for their bonds since investors can buy new bonds in the market with higher coupons. The decline in value of the bond that is due to increase in interest rate is known as interest rate risk. This interest rate risk can be measured using duration.

Duration, expressed in years, is a measure of the sensitivity of the bond’s price to a change in interest rates. If you know the duration of your bond, you can estimate the magnitude of the fall in price when interest rate goes up by 1%. Suppose the bond has a duration of 5 years. This means that if interest rates were to increase by 1%, the price of the bond would fall by 5%.

If the duration of the bond is 1 year, an increase of 1% interest rate would only cause the bond to fall by 1%. A longer duration bond would experience greater volatility in prices when interest rate changes, i.e greater interest rate risk. Weighted duration for the bond funds could be interpreted in the same manner, i.e higher weighted duration indicates higher interest rate risk.

Knowing the riskiness of your bond Fund

We are providing the duration and average credit rating of selected bond funds from Affin Fund Management Berhad and RHB Investment Management Sdn Bhd. The RHB Bond Fund has an average credit rating of AA2, which means that the majority of underlying bonds is investment grade. As for Affin Capital Fund,  majority of its underlying bonds has an average credit rating of A. This means that there is a higher credit risk associated with Affin Capital Fund; thus, its yield should be higher for investor to take on the higher risk.

On the other hand, the RHB Asian Total Return Fund has a weighted duration of 6.58 years which is longer than that of the RHB Islamic Bond Fund. This suggests that the RHB Asian Total Return Fund would suffer more if the interest rates for investment grade corporate bonds move up.

Average credit risk rating and duration of the bond fund would give investors an indication of how risky the bond fund is. Coupled with the information on yields, an investor can shop around for the bond fund that carries the highest weighted YTM among bond funds with similar average credit risk rating and duration.

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