Mutual Funds Question

A question that deals with the level of risk associated with different types of mutual funds, or even segregated funds. 

Hi everybody. Cory Snyder here, Sales Director at SeeWhy Learning.

You probably already know that SeeWhy offers a full suite of mutual fund exam preparation study tools. Well, it’s getting even better. Our team’s been hard at work on a brand new video series where a study coach helps students by taking up some of the questions found in the SeeWhy practice exams. In a moment, we’re going to transition to one of these videos where Coach Rebecca works through a question found in the SeeWhy study tools.

I’d really like to hear what you think after you watch this video. If like this approach, let us know by leaving a comment and hitting that like button on the YouTube Video.

And now here’s Coach Rebecca.

In this video, I’m going to work through a question that deals with the level of risk associated with different types of mutual funds, or even segregated funds. More specifically, it gets into the risk profile of a mortgage fund as compared to a bond fund.

There are two nuggets of knowledge that will help you with the risk level associated with the different fund types.

Nugget #1 is one of the things we’re known for here at SeeWhy learning; a great memory aid. In the SeeWhy study guide and the key concept video lessons, there’s a story about a mortgage broker saving his client money by negotiating a lower interest rate.

This leads to the following memory aid:

“My Mortgage Broker Brought Down Every Rate Substantially.” With the first letter of each word helping to jog your memory about the different fund types from lowest risk to highest risk. M for money market fund, M for mortgage fund, B for bond fund, B for balanced fund, D for dividend fund, E for equity fund, R for real estate fund, typically commercial, and S for specialty fund.

Now I want to stress that while this is only a generalization, it’s still super helpful. In the real world, though, be sure to read the Fund Facts Document, to learn all the essential facts. For example, if a bond fund is primarily invested in high-risk junk bonds, obviously that would increase its risk profile, perhaps to even more than an equity fund.

Now, this question focuses on mortgage funds versus bond funds. Both mortgages and bonds usually involve a fixed interest rate for a specified period of time. So why is a bond fund generally riskier than a mortgage fund? This brings us to nugget number two, which has to deal with the term of the investment.

Let’s assume you’re on the investment side of the equation. In other words, you’re the lender. If the fixed interest rate you’re receiving is only 1% and interest rates increase, what does that mean for your fixed rate investment? Well, it’s comparatively less attractive, right? Therefore, this would negatively impact its market value. As an investor, you would be thinking, “I can’t wait for my investment to mature so I can get my principle back, and reinvest at a higher rate.” Makes sense, right?

So here are the takeaways:

The shorter the term of the investment, the lesser the interest rate risk.

The longer the term of the investment, the greater the interest rate risk.

A mortgage fund has less interest rate risk as compared to a bond fund for the following two reasons:

First, mortgage terms are generally shorter, with the maximum term often being five years. In contrast, bonds can have terms of 30 years or more.

Second, mortgages typically require monthly interest payments, whereas bond interest payments are typically semi-annually.

With all this in mind, let’s circle back and tackle the question by analyzing each available answer.

This answer looks pretty good. Mortgage terms are generally shorter than bond terms. The interest payments on a mortgage happens sooner, usually every month. Whereas bonds typically pay interest semi-annually. And mortgage rates tend to change less frequently than bond yields. I haven’t mentioned bond yields yet, but they tend to change daily. Mortgage rates, on the other hand, don’t tend to fluctuate as often.

Let’s put a tentative check mark here and see if we can eliminate the other available answer choices.

What about this one? It’s true that mortgages are secured by a real property. However, bonds are also secured by some form of asset. Remember, when a corporate debt security is unsecured, it’s actually referred to as a debenture, not a bond. So this answer is wrong and can be eliminated.

This one is wrong too. Bonds and mortgages are considered a form of debt. The borrower must make the agreed upon payments or could face serious legal issues. Let’s cross it out.

Finally, as we already discussed, bonds can have terms of 30 years or more, which is much longer than available mortgage terms in Canada. So we could eliminate this answer as well.

So let’s go ahead and select the answer I initially flagged as correct. Now that we have eliminated the other three answers for sure, it must be the right one. And the answer key confirms we’re correct.