What You Are Actually Investing in a Fixed Income Fund.

Fixed income security or fixed income fund is touted as the safest asset class in unit trust investment.

However, is it as safe as fixed deposit?

Fixed income funds invest in government and corporate bonds. I previously wrote about bond and how bond prices affect you bond fund NAV as it fluctuates according to business cycle. This is systematic risk, which is inherent to the entire market. You cannot control this but the good thing is, it is somewhat predictable to certain extent. You just know that a recession is looming in the horizon by looking at the various economic indicators.

Unsystematic risk, on the other hand, is the investment risk which is specific to a fund only. The more difficult risk to predict in a bond fund is the risk of default. It is like, I sell you bond, which is akin to me borrowing money from you. Suddenly, I go bankrupt and cannot repay your money.

Fixed income securities normally hold a portfolio of government and corporate bonds. Imagine that if the bond fund you were invested in holds government bond of Greece. Your money invested in any fixed income securities will go down the drain.

Corporations also issue bonds besides shares. However, if the company business takes a turn for the worse for an extended period of time and keeps on borrowing money until its cash flow become negative, it will go bankrupt eventually. When it no longer able to fulfil its financial obligations to its creditors and bond holders, it is said to be in default state.

Investors of RHB Islamic Bond fund recently encountered such unfortunate incident in Oct 2011. This occurred when a corporate bond in its portfolio defaulted. Read my previous post about an event case study on how fixed income security is not as risk-less as you previously thought.

Watch out intently for the risk of default in the fixed income securities’  bond portfolio. There’s no short cut to this simple tip: Read its annual and interim reports for all the bonds’ rating in its portfolio. I smell a rat if any of the bonds in a fixed income fund portfolio gets downgraded to junk bond grade.

LCF on Personal Finance Malaysia

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