Question

It might be surprising to find out that the market for fixed income securities is significantly larger than the more well-known market for equity securities. What types of investors are usually more interested in fixed income types of investments and why? It has often been suggested by so-called experts that individual fixed income investors should invest through bond mutual funds. Can you think of reasons why this suggestion makes sense or doesn't make sense?

Answer 1

Part a: What types of investors are usually more interested in fixed income types of investments

To understand what type of investors are more interested in fixed income securities, we need to first understand the characterstics of fixed income securities in general.

Generic charaterstics of 'Fixed Income Securities':

• Regular Interest Income: Most of the securities carry a fixed or variable coupon on the invested amount
• Senior to Equity holders in worst case: In case of liquidation and/or settlement of assets, fixed income securities' holder (secured/unsecured) are paid first and then residual amount goes to equity holders
• Fixed Tenure: Carry a fixed tenure within which the money is returned to investors
• Can be Market Linked/Traded: Some of the fixed income securities can be traded just like equity instruments

The abovementioned characterstics are best suited to an investor which requires the following:

• Periodic income - in form of interest/coupon
• Safety of the invested amount - better placed as compared to equity
• Satisfied with moderate returns - lower than equity investment
• Long holding period - investors money is backed with long term liabilities

Hence, the investors which would be primarily investing in fixed income securities are:

• Banks & Financial Institutions - As loans / advances given to companies
• Insurance Companies - As a major part of their investment portfolio
• Asset Management Companies - As a part of their diversified investment portfolio
• Pension Funds - value security of the investment amount
• Wealth Management Funds - to diversify portfolio
• Individual Investors - to diversify portfolio

Part b: Why investors should invest through bond mutual funds

Investment has two basic steps: Asset Allocation (Debt/Equity/etc.) and Security Selection (SecurityA/SecurityB/etc.). Once, an investor has narrowed down an amount to be invested in the fixed income securities; it is adviseable to diversify the investment into various securities.

Example: If an investor decides to invest $100,000 to be invested in bonds of AA+ rated issuers. Then they should further narrow down multiple bonds in which this can be distributed. For ex: $25,000 invested in four type of bonds.

If an investor tries to diversify its portfolio amongst multiple bonds, then they need to do the following over the holding period of their investment:

• Track the cash flows from the bond
• Track the performance of the bond issuer
• Rebalance the portfolio at regular intervels
• Exit specific investment if required

Bond mutual funds provide all the benefits of diversification along with the mitigation of the abovementioned risks. Hence, it is adviseable to invest in fixed income securities through bond mutual funds.