Saturday, May 26, 2007

Bond and money market fund

Dear Mr Tan,

What is the difference between a bond fund and a money market fund? It seems that both funds pay a rate of return that is linked to the interest rate?



The bond fund is invested in bonds, using from 2 to 15 years of duration. The yield on these investments is locked up for the period. If the yield on newly purchased bonds drops, the value of the bond fund will increase (as the yield of the fund has been locked in). Similarly, if the yield on bonds increase, the value of the bond fund will drop.

Hence, a bond fund is sensitive to changes in the yield on bonds, and will move in the opposite direction. A change of 1% in the yields on bonds can cause a change of 3% to 10% in the price of the bond fund.

A money market fund is invested in short term investments with a maturity of 1 to 12 months. It will also be impacted by changes in the yields of these investments, but as the locked in period is short, the impact of these changes is small.

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