Fixed-income Funds Overview
Fixed-income funds are designed to provide a steady stream of income and safety of principal, rather than capital appreciation. Funds in this category must invest at least 95% of their non-cash assets in fixed-income securities.
Types of Fixed-income Funds
This category includes the following fund types:
- Canadian short-term fixed income
- Canadian long-term fixed income
- Canadian inflation-protected fixed income
- Global fixed income
- High-yield fixed income
High-yield Fixed-income Funds
High-yield fixed-income funds invest in fixed-income securities with a non-investment-grade credit rating. These funds typically offer higher yields to compensate for the increased level of risk.
Investment Strategy and Risk
Otherwise, all mutual funds in the fixed-income category invest primarily in high-quality government and corporate debt securities. Their degree of volatility is primarily related to interest rate fluctuations. However, fund managers may attempt to minimize this risk by adjusting:
- Duration of the portfolio
- Mix of low- and high-coupon bonds
Interest rate volatility is the main risk associated with this type of fund. Funds that invest in corporate bonds are also exposed to default or credit risk.
Source of Returns
The primary source of returns from bond funds is interest income. The investor may also receive a capital gain if the fund sells some of its bonds at a profit.
Key Risks
Interest Rate Risk
Interest rate changes have a significant impact on fixed-income funds. When interest rates rise, bond prices generally fall, and vice versa. This effect can lead to volatility in the fund’s value.
Credit Risk
Credit risk refers to the possibility that a bond issuer may default on its payments. High-yield bonds have higher credit risk compared to investment-grade bonds.
Default Risk
The risk that the issuer of the bond will be unable to make principal or interest payments as they come due.
Mathematical Example: Duration and Interest Rate Changes
To measure the risk sensitivity of bond prices to interest rates, you can calculate the duration of a bond. Here’s the formula for Macaulay Duration (
(D_M)):
$$
D_M = \frac{1}{P}\sum_{t=1}^T t \times \frac{C_t}{(1+y)^t}
$$
Where:
- (P) = Current bond price
- (C_t) = Cash flow at time (t)
- (T) = Total number of periods
- (y) = Yield to maturity per period
Frequently Asked Questions
What are fixed-income funds?
Fixed-income funds are investment funds that primarily invest in bonds or other debt securities to provide a steady income and preserve capital. They invest at least 95% of their non-cash assets in fixed-income securities.
How do fixed-income funds manage interest rate risk?
Fund managers may adjust the duration of the portfolio and switch between low- and high-coupon bonds to mitigate risks associated with interest rate fluctuations.
What type of securities do high-yield fixed-income funds invest in?
High-yield fixed-income funds invest in bonds or other debt securities with non-investment-grade credit ratings, offering higher yields to compensate for higher risk.
Key Takeaways
- Fixed-income funds focus on providing a steady stream of income and safety of principal.
- They invest at least 95% of non-cash assets in fixed-income securities.
- There are various types such as Canadian short-term, Canadian long-term, Canadian inflation-protected, global, and high-yield fixed income.
- Interest rate volatility and credit risk are the primary risks.
- The primary returns come from interest income, with potential capital gains from bond sales.
Glossary
- Fixed-income Securities: These are debt instruments that provide returns in the form of regular (or fixed) interest payments and the repayment of the principal at maturity.
- Non-investment Grade: Bonds with a lower credit rating (below BBB) offered higher interest rates to compensate for higher risk of default.
- Duration: A measure of the sensitivity of the price of a bond to a change in interest rates.
📚✨ Quiz Time! ✨📚
## What is the primary objective of fixed-income funds?
- [x] To provide a steady stream of income and safety of principal
- [ ] To maximize capital appreciation
- [ ] To engage in high-frequency trading
- [ ] To invest in equity securities
> **Explanation:** Fixed-income funds aim to offer steady income and ensure the safety of the principal, rather than focusing on capital appreciation.
## What percentage of a fixed-income fund's non-cash assets must be invested in fixed-income securities?
- [ ] 75%
- [ ] 85%
- [ ] 90%
- [x] 95%
> **Explanation:** Funds in the fixed-income category must invest at least 95% of their non-cash assets in fixed-income securities.
## Which of the following is not a type of fixed-income fund mentioned?
- [ ] Canadian short-term fixed income
- [ ] Canadian long-term fixed income
- [ ] Global fixed income
- [x] Canadian equity income
> **Explanation:** Canadian equity income is not listed as a type of fixed-income fund. The types include Canadian short-term fixed income, Canadian long-term fixed income, Canadian inflation-protected, global fixed income, and high-yield fixed income.
## High-yield fixed-income funds primarily invest in which type of securities?
- [ ] Investment-grade equities
- [ ] Government securities
- [x] Non-investment-grade credit rating securities
- [ ] Preferred shares
> **Explanation:** High-yield fixed-income funds invest in fixed-income securities that have a non-investment-grade credit rating.
## What is the main risk associated with fixed-income funds?
- [ ] Liquidity risk
- [ ] Market manipulation
- [x] Interest rate volatility
- [ ] Currency risk
> **Explanation:** Interest rate volatility is the main risk associated with fixed-income funds, as changes in interest rates can affect bond prices and yields.
## For fixed-income funds that invest in corporate bonds, which additional risk do they face?
- [ ] Currency risk
- [x] Default or credit risk
- [ ] Inflation risk
- [ ] Political risk
> **Explanation:** Fixed-income funds investing in corporate bonds are exposed to default or credit risk, which is the possibility that a bond issuer may default on payments.
## What is the main source of returns from bond funds?
- [ ] Dividends
- [ ] Capital gains
- [x] Interest income
- [ ] Stock price appreciation
> **Explanation:** The primary source of returns from bond funds is the interest income generated from the bonds held in the portfolio.
## How do fund managers attempt to compensate for changes in interest rates?
- [ ] By increasing the allocation to equity securities
- [ ] By using leverage
- [ ] By adjusting the portfolio's cash position
- [x] By changing the duration of the portfolio and the mix of low- and high-coupon bonds
> **Explanation:** Fund managers may change the duration of the portfolio and adjust the mix of low- and high-coupon bonds to compensate for interest rate changes.
## What type of bonds do the fixed-income funds typically invest in?
- [ ] High-risk equities and derivatives
- [ ] High-quality equity securities
- [x] High-quality government and corporate debt securities
- [ ] Foreign currency bonds
> **Explanation:** Fixed-income funds primarily invest in high-quality government and corporate debt securities.
## If a bond fund sells some of its bonds at a profit, what additional type of return might an investor receive?
- [ ] Dividend income
- [ ] Miscellaneous income
- [ ] Rental income
- [x] Capital gain
> **Explanation:** In addition to interest income, an investor might receive a capital gain if a bond fund sells some of its bonds at a profit.