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Sunday, July 31, 2011

Bond Dividend vs Bond fund

 Bond Dividend

A dividend that is paid in stock or bonds rather than cash. A stock dividend may be declared when the company is cash poor and cannot afford a dividend otherwise. They are generally not considered desirable because one must pay gains tax on stock dividends, even though there is no cash gain for the shareholder. It is also called a scrip dividend..
A bond in which coupon payments come in the form of more bonds, rather than cash. At times, the investor has the option of choosing whether to accept cash or payment-in-kind, but more often this option resides with the issuer. A problem with PIK bonds for the issuer is the fact that it becomes tempting to pay coupons with more debt rather than cash when the company has a liquidity problem. Of course, doing this often only adds to the issuer's liquidity problems. This type of bond was not unusual during the private equity boom in the mid-2000s, but became rare during the credit crunch at the end of the decade.

 Explanation –
Generally, dividend is paid in the form of cash or stock. But there is a practice in western countries of paying dividend in the form of bonds or other securities, A company may issue bonds to the shareholders promising that they will pay interest at a future date. If has a longer maturity date than Scrip dividend. It always carries interest. It means the company pays interest every year on the bonds issued in lieu of dividend; The Company is thus incurring liability for future in return for nothing except credit for declaring dividend.

Some companies may issue shares of its subsidiary company, which it had acquired in lieu of dividend or the subsidiary company may give shares of holding company which it is holding to its shareholders for dividend. Some companies may give shares of other companies in which it had made investment of its funds. But this practice is not seen in India nor legally allowed.

Reasons for bond dividend distribution:-
1.company is cash poor 
2.cannot afford a dividend otherwise
3.no cash gain for the shareholder
4.one must pay gains tax on stock dividends
5.Having liquidity problems
6.during the credit crunch

2)  Bond fund.
A bond fund is a collective investment scheme that invests in bonds and other debt securities. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bondsA bond mutual fund sells shares in the fund to investors and uses the money it raises to invest in a portfolio of bonds to meet its investment objective -- typically to provide regular income.The appeal of bond funds is that you can usually invest a much smaller amount of money than you would need to buy a portfolio of bonds, making it easier to diversify your fixed-income investments
Factor affecting the bond funds
Bond funds may also be classified by factors such as type of
1.      yield (high income) 
2.      term (short, medium, long)
3.       some other specialty such as zero-coupon bonds,
4.       international bonds,
5.      multisector bonds
6.       convertible bonds.

Types

Bond Funds can be classified by their primary underlying assets:
  • Government bond: These funds invest primarily in bonds issued by the U.S. Treasury or federal government agencies, which means one don't have to worry about credit risk .Due to the safety, the yields are typically low.
  • High-yield bond funds; There is more risk, however, and for that, you get higher yields - usually 3 to 10 percentage points more than safer bond funds. These funds tend to shine when the economy is on a roll, and suffer when the economy is fading (increasing the chance of default).
  • Corporate bond funds: Bonds are issued by corporations. All corporate bonds are guaranteed by the borrowing (issuing) company, and the risk depends on the company's ability to pay the loan at maturity. Some bond funds specialize in junk bonds, which are corporate bonds carrying a higher risk, due to the potential inability of the issuer to repay the bond. Bond funds specializing in junk bonds – also known as "below investment-grade bonds" – pay higher dividends than other bond funds, with the dividend return correlating approximately with the risk.
  • Municipal bond funds Bonds issued by state and local governments and agencies are subject to certain tax preferences and are typically exempt from federal taxes. In some cases, these bonds are even exempt from state or local taxes.

Calculation of bond fund

For a bond fund, the calculation requires some imaginative thinking. For "coupon rate" enter the fund's yield and use the average weighted maturity from your fund's prospectus to create a maturity date for the fund. (Yes, we know, most bond funds don't mature, but the average maturity of all bonds in the fund gives you a functional fund maturity.)

Advantages over individual bonds

  • Management: Fund managers provide dedicated management and save the individual investor from researching issuer creditworthiness, maturity, price, face value, coupon rate, yield, and countless other factors that affect bond investing.
  • Diversification: Bond funds invest in many individual bonds, so that even a relatively small investment is diversified—and when an underperforming bond is just one of many bonds in a fund, its negative impact on an investor's overall portfolio is lessened.
  • Automatic income reinvestment: In a fund, income from all bonds can be reinvested automatically and consistently added to the value of the fund.
  • Liquidity: You can sell shares in a bond fund at any time without regard to bond maturities.

Disadvantages over individual bonds

Although funds do pay dividends, these are not fixed like the interest payments of an actual bond. A fund's dividend may decrease. Similarly, a fund's NAV (share price) may also decrease over time. When buying an individual bond, you know that you will get 100% of the bond's face value back at maturity.