In recent times, the question of which bond fund to purchase has been surfacing frequentlyThis query, however, is far more complex than merely choosing a stock fundWhen asked what type of bond fund one might be interested in, it's evident that very few people can articulate the specific kind of bond fund they desireUnderstanding this complexity is essential for both new and seasoned investors as they navigate the intricate world of bond funds.

Aiming to clarify the critical points one should consider when selecting bond funds is crucialWe must adopt a clear methodology to approach our choicesBy defining our investment strategy from the outset, we can simplify the selection process significantlyGrasping the types of bond funds available allows investors to sidestep potential pitfalls that could result in losses or inappropriate investment choices.

Step One:

Selecting the Correct Classification of Bond Funds

Currently, there are over 2,000 bond funds available in the market, and typically, there are three primary classification strategies to navigate this vast selection

Each classification encompasses two or three options, thereby limiting the choices available and giving investors a clearer path in making decisions.

No1 Categorized by Investment Scope: Pure Bond Funds and Mixed Bond Funds

There are three options: Pure Bonds, Level One Bond Funds, Level Two Bond Funds

Bond funds are defined as investment vehicles that allocate more than 80% of their assets to bonds

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Based on investment scope, they can be split into two main categories: pure bond funds and mixed bond funds, which are fundamental classifications commonly encountered.

Pure bond funds only invest in bonds, excluding any equities or other asset types such as convertible bonds.

Mixed bond funds are permitted to participate in stock, convertible bond investments, etcThese can be further refined into Level One Mixed Bond Funds and Level Two Mixed Bond Funds.

Level One Mixed Bond Funds can engage in initial stock offerings and capital increases, whereas direct trading in the stock secondary market is not allowed

These funds typically hold a certain proportion of convertible bonds.

Level Two Mixed Bond Funds can directly invest in stocks among other asset classes, generally with stock holdings not exceeding 20%.

The primary distinction between these types arises from their ability to invest in stocks, methods of participation, and the proportion of equity-related assets held.

Consequently, each type of bond fund carries its own unique risk-return profile.

Pure bond funds experience minimal fluctuations, with the lowest long-term returns.

Level One and Level Two bond funds exhibit higher fluctuations when compared to pure bond funds

Notably, Level Two funds demonstrate even higher volatility but also offer the potential for greater long-term gains.

For instance, let’s consider E fund management, which has a robust array of fixed income productsTheir offerings include E Fund Credit Bond (pure bond), E Fund Enhanced Return (Level One bond fund), and E Fund Steady Income (Level Two bond fund).

No2 Classified by Operation Method: “Ordinary Open-ended” and “With a Defined Closure Period”

Three Options Available: Open-ended, Periodically Open, Minimum Holding Period

Conventional open-ended bond funds normally allow subscription and redemption on trading days

Keep in mind that newly established funds usually have an initial closure period that does not exceed three months, during which redemptions are not permitted.

To ensure that the duration of the holding portfolio remains relatively stable and to enhance return potential, some bond funds implement periodic openings or minimum holding durations to align their investment strategies.

For example, a bond fund categorized as “periodically open” will have operating phases consisting of a “closure period” followed by an “open period.” At the close of each closure period, investors can only conduct subscription or redemption activities during the open phase.

A minimum holding period generally refers to those funds whose names will include terms like “xx years/months holding.” While they may be subscribed to during trading days, each share must be held for a minimum set duration before redeeming.

E Fund provides a comprehensive overview of three varieties of bond funds differentiated by these operational methods: ordinary open, periodically open, and minimum holding period, prompting investors to select based on liquidity preferences.

No

3 Grouped by Investment Strategy: Active and Passive Index Funds

Two Options: Active, Passive

The classifications of active and passive bond funds closely resemble those of stock funds.

Active bond funds are typically managed by fund managers who actively select individual securities and allocate assets in a bid to achieve investment returns that surpass their benchmark.

Passive index bond funds aim to replicate the performance of designated bond indexes (like government bond indexes, policy financial bond indexes) by constructing an investment portfolio that reflects a subset or the entirety of that index.

Although the size of index bond funds remains relatively smaller, their growth trajectory is promising

Recent data available until March 31, 2023, highlights that the number of bond index funds in China remains limited compared to active options, about 200, and their total market capitalization is below 500 billion RMB.

Utilizing the classifications outlined here effectively simplifies the choices available to usFor example, if you prefer your investment to be unaffected by stock market fluctuations, a pure bond fund would be suitableConversely, if you desire maximum liquidity, a conventional open fund would be idealShould your preference lean towards a fund manager actively managing investments, an active bond fund might be the choice for youClarifying these preferences lends clarity to the decision-making process.

Where Do Bond Funds Derive Their Returns?

Understanding the origin of returns from bond funds is intrinsically linked to their classification

Gaining insight into this can significantly enhance investment decisions.

Returns derived from the bond investment component of bond funds primarily include interest income and capital gains and may also feature leverage income if leveraged strategies are employedLevel One and Level Two funds also have gains associated with equity investments.

Interest Income

Bonds can be viewed as standardized “IOUs”; inherently, this means interest is involved

Provided that the bonds do not present default risks, bond funds earn their interest incomes reliably from their holdings.

This income correlates primarily with the bonds’ coupon rates, which are influenced by the bonds’ duration and credit rating. In general, under identical conditions, longer-duration bonds and those with lower credit ratings translate to higher coupon rates and, consequently, greater interest income.

In the case of bond funds, longer-term holdings can yield greater interest income, thereby facilitating higher overall returns.

For instance, consider the E Fund Bond Index Funds, with three-year annualized returns revealed as 2.75% and 3.50% respectively as of March 31, 2023, based on their duration of 1-3 years and 7-10 years.

For investors in actively managed bond funds, if the holding period of bonds is not clearly stated, it is advisable to refer to the fund’s semi-annual or annual report, as it includes interest rate risk sensitivity analyses that provide insights into the portfolio duration at the time of reporting.

Capital Gains

Once bonds are issued, they may be traded in the secondary market

However, market prices vary, influenced by multiple factors including market interest rates, supply and demand, and credit conditions.

For example, let’s assume a bond is purchased at 100 RMB; should interest rates decline and result in an environment where existing coupon rates surpass market rates, the bond may rise to 102 RMB, yielding a capital gain of 2 RMB.

When valued based on market prices, a rise in the market price of held bonds results in an appreciation of fund net worth, thus generating capital gains.

Leverage Income

Many bond funds utilize leveraging strategies as well.

Investors can calculate leverage within fund statements by dividing total fund assets by net assets

According to the applicable regulations, the leverage limit for non-closed bond funds is capped at 140%, while closed funds or periodically open funds can leverage up to 200% during their closed operation periods.

For example, the E Fund 3-5 year Treasury Index Fund's contract states that “the total fund assets may not exceed 140% of the net assets.”

Leverage strategies essentially allow funds to collateralize existing bonds to borrow relatively lower-cost capital to invest in higher-yielding bonds, thereby enhancing fund incomeLeveraging enables bond funds to amplify investments through systematic “borrowing.”

However, caution is advised as leverage can be a double-edged sword, magnifying both potential returns and inherent risks simultaneously.

Equity Investment Gains in Level One and Level Two Funds

Both Level One and Level Two funds can earn returns through stock holdings, benefiting from dividends as well as price appreciation.

In practical investment scenarios, it's prudent to consult periodic bond fund reports to ascertain whether stocks have been included in the portfolio and to what degree to better match one's risk appetite.

Additional revenue streams are available beyond the four mentioned above.

For instance, QDII bond funds have direct exposure to foreign assets and are subject to currency fluctuations

Should the RMB depreciate relative to foreign currencies, foreign assets convert to a higher RMB amount, generating “exchange income.” Some bond fund regulations even permit investments in financial derivatives, which could also act as revenue sources for funds.

In conclusion, in ranking bond funds according to risk and return levels, they classify as follows: Pure Bond Funds < Level One Bond Funds < Level Two Bond Funds.

If fluctuations are undesirable or expectations for the stock market are poor, pure bonds would be an appropriate selectionFor those who can tolerate some volatility (seeking to enhance bond returns further), Level One bond funds may be the solution