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    What You Need to Know About Investing in Bond Mutual Funds

    by Annette Thau

    What You Need To Know About Investing In Bond Mutual Funds Splash image

    For every type of bond that exists, there exists a corresponding bond fund. There are bond funds that invest in Treasuries, in municipals, in mortgage-backed bonds, in international bonds, of every credit quality, and in every imaginable combination. Bond fund returns vary from fund to fund, from category to category, and range from the very good to disastrous. Moreover, returns vary widely over time: in 1994 and 1999, returns for almost all bond funds were very poor. But in 2000 and 2001, returns for bond funds were very good and, in fact, overall exceeded those of mutual funds investing in stocks.

    Bond funds are a unique investment product. True, they share a number of characteristics with mutual funds that invest in stocks. They also share some characteristics with individual bonds.

    But bond funds and individual bonds should not be viewed as interchangeable investments. Indeed, bond funds differ from individual bonds in some important respects. There is an enormous amount of information available concerning mutual funds, and that includes bond funds. Quite a lot of this information is confusing. This article will focus on some of the basics that you need to understand when choosing a bond fund.

    Expenses and Returns

    Let’s first discuss some characteristics that mutual funds investing in bonds share with those investing in stocks.

    The first characteristic of any mutual fund (stock or bond) is that you can buy or sell shares of a mutual fund any day the markets are open for trading at the closing price of the fund that day. That price is its net asset value, or NAV for short. That value is calculated on a daily basis by dividing the value of the securities in the fund (in this instance, a portfolio of individual bonds) at the close of trading by the number of shares outstanding in the fund. Changes in net asset value translate directly into changes in the value of your assets in that fund. If you own 1,000 shares of the Many Happy Returns Bond Fund and on Monday the net asset value of that fund is $10.00, then the value of your assets in that fund is $10,000. If on Friday, that net asset value has risen to $10.05, then your shares in that fund are now worth $10,050. If, on the other hand, the net asset value has declined to $9.95, then your assets in that fund are now worth $9,950. The net asset value of any mutual fund can be expected to change daily. In bond funds, daily changes are usually small, but over time the changes can be significant. Further on in the article, we will address the issue of what causes these changes.

    If you invest in any mutual fund, you are familiar with the expenses of investing through mutual funds. Readers of the AAII Journal will be familiar with the two major types of expenses. The first are commissions, also called “loads.” Those can be paid when you buy a fund (front-end loads) or when you sell a fund (back-end loads). Typical commissions are in the 4% to 5% range. If you think about it, it makes no sense to pay a commission to buy a bond fund: at the current level of interest rates, you are giving up interest income from the fund for approximately one year!

    The second major expense is the actual cost of managing the fund. This expense is called the expense ratio. Perhaps surprisingly, expense ratios for bond funds vary widely—from around 20 basis points (that is 1/5 of 1%) per year, to as high as 150 basis points (1.5%) per year. These expenses come out of earnings of the fund on an annual basis. The higher the expense ratio, the lower your return. If a fund is earning 5% on the bonds in its portfolio, you would earn 4.8% if you invest in the fund with the 20-basis-point expense ratio, and 3.5% in the fund with the 1.5% expense ratio.

    It is a truism in life that you get what you pay for. So you might think that a bond fund with a higher expense ratio will in some fashion be superior to one managed for much less. However, it’s precisely the opposite. In order to compete with their lower-cost cousins, managers of funds with higher expense ratios have to invest in riskier bonds in order to reach for yield. The result may be an equivalent return, but with more risk. It never makes any sense to take on more risk if a higher quality, lower risk fund is available for the same yield.

    Total Return and Yield

    Many individual investors who buy bond funds do so primarily to receive the stream of income paid out by bond funds. Most bond funds pay out a distribution on a monthly basis, which is an aggregate of the interest income earned by the bonds in the portfolio of the fund. You can reinvest this income, or receive a monthly check. This income is known as the fund’s distribution income, or its yield. In order to permit investors to accurately compare the returns of bond funds to each other, yield is calculated for all bond funds according to a formula laid down by the Securities and Exchange Commission, called, appropriately enough, the fund’s 30-day SEC yield. This is primarily a snapshot of the distributions made by a bond fund for the previous 30 days.

    Bear in mind, however, that higher yield does not necessarily translate into higher total return. That is because total return for a bond fund consists of yield plus or minus any changes in net asset value. As an example, let’s assume that you are investing in a bond fund that pays 5% in distribution income over a year’s time. That will be the 30-day SEC yield quoted by the fund. At the end of the year, if the net asset value of the fund is exactly what it was when you bought the fund, the total return will be roughly equivalent to its yield, that is, 5%. (For the sake of simplicity, I am ignoring interest-on-interest earned if you reinvest monthly distributions in the fund.) If at the end of one year, the net asset value of the fund has gone up by 5%, then the total return of the fund for that year will be 10% (that is, 5% increase in the net asset value of the fund, plus the 5% interest income). If, on the other hand, the net asset value of the fund has declined by 5%, then total return for the bond fund, for that year, will be zero (5% interest income minus the 5% decline in net asset value). In this last example, the total return is zero even though the fund has paid out the advertised yield of 5%.

    Once past these basics, investing in bond funds becomes more complex. For one thing, there are now more than 4,000 bond funds. They differ enormously in the types of bonds they buy, which range from familiar and seemingly safe bonds such as municipals and mortgage-backed securities (GNMAs) to highly speculative offerings (for example, bonds of so-called “emerging markets” and “junk” bonds). In addition, investing in bond funds is quite different from investing in individual bonds.

    Bonds vs. Bond Funds

    Let’s first examine how bond funds differ from individual bonds.

    When you buy an individual bond, the bond has a stated maturity date that can range from a few months to 30 years. When the bond matures, it is redeemed—usually at par, which is almost always $1,000 per bond. Each year that you own a bond, its maturity goes down by one year. For example, if you buy a bond with a 20-year maturity, in one year it will have a maturity of 19 years; in 10 years, its maturity will be 10 years; in 19 years, only one year. Each year, regardless of what is happening to interest rates, the price of the bond moves closer to par. On the date that the bond matures, it will be redeemed at par, that is, $1,000 per bond.

    A bond fund, on the other hand, is made up of a portfolio of bonds that are continually turned over. There is not one single date on that the entire portfolio matures (with the exception of bond funds that invest in zero-coupon bonds). Consequently, the average maturity of a bond fund remains relatively constant. If you buy a municipal bond fund investing in long-term bonds, you can expect that it will always remain a long-term bond fund. That has important consequences.

    The first is that it will continue to have the same exposure to interest rate risk. For most bond funds, interest rate risk is the principal reason the net asset value of the fund will go up and down—in response to the changes in interest rates. The fact that you can sell shares in a bond fund any day you want does not mean that you can sell at the price you paid. In fact, there is no way to know at what price you will be able to sell shares in a bond fund any time after you buy it. The net asset value of the fund may be close to what you paid, higher or lower. Unless you are able to predict interest rates (highly unlikely!), you cannot know its price at any future date.

    Secondly, because the portfolio of a bond fund does not mature on any single date, the yield quoted by a bond fund cannot be compared to the yield to maturity quoted for individual bonds—which assumes, among other factors, that the bond will be redeemed at par. As noted above, the yield quoted for a bond fund, called its 30-day SEC yield, is primarily a snapshot of the distributions of the fund for the last 30 days.

    Volatility

    If you are like most investors who buy bond funds, you are investing for a stream of income. But, as noted earlier, the value of your assets in the fund can be expected to fluctuate as the net asset value of the fund goes up and down in response to changes in interest rates.

    The first factor to be aware of, therefore, is how volatile a bond fund is likely to be, because that will have a major impact on total return. In years such as the preceding two years, the total return of many bond funds has exceeded interest income (that is, monthly distributions) because interest rates have gone down. Total return has consisted of the interest income earned by the bond funds, plus a chunk of appreciation in net asset value. In contrast, in 1999, the net asset value for many long-term bond funds declined by between 10% and 20%. As a result of that rise in interest rates, even though interest income rose through the year, total return was negative. Assets in the fund were worth less at the end of the year than at the beginning. That is why owning bond funds when interest rates are declining is great, but owning bond funds when interest rates are rising is painful.

    It is not difficult to predict how volatile the net asset value of a bond fund is likely to be. The major factor in the volatility of many bond funds is the exposure to interest rate risk. As a general rule, the longer the maturity of a bond fund, the more the net asset value will go up and down in response to changes in interest rates. There are two numbers that can give you a very good idea of how much volatility you can expect. The first is known as the fund’s average weighted maturity, which is the average maturity of all the bonds in the fund. Maturities can be roughly grouped as short (under two or three years); intermediate (between three and 10 years); and long (higher than 10 years). Volatility is lowest for the short-term funds and highest for long-term funds.

    An even more precise number is the duration of the fund. Duration is a somewhat complex concept based on the size and timing of all the cash flows of bonds. For purposes of this article, what is important is that duration is a number that measures the sensitivity of a bond fund to interest rate risk. Let us assume, for example, that a bond fund has a duration of five years. If interest rates in that sector of the bond market change by 1%, going, for example, from 5% to 6%, or from 6% to 7%, then the net asset value of the fund will move by the same amount as the duration of the fund: that is, by 5%. If the duration of the fund is two years, then for the same 1% move in interest rates, the net asset value of the fund would go up or down by 2%.

    A fund with a duration of three years or less will have low volatility. That means that the net asset value will not go up and down a lot. If the duration is six years or higher, volatility will be high. The net asset value will go up and down a lot in response to interest rate changes.

    In the world of bonds, as elsewhere, there are trade-offs. The net asset value of bond funds with lower average weighted maturities and durations will go up and down less than that of their longer-term counterparts. But the yield will be lower than for longer-term bond funds. Therefore, you need to keep this trade-off very clearly in your mind when you buy shares in a bond fund. Focusing on the highest income (and therefore the highest yields) means that you may incur greater volatility in the value of your assets in the fund.

    You can handle that trade-off in a number of ways. First, don’t put money in any long-term bond fund if you know you are going to need that money in a very short time (a couple of years or less). If you are investing primarily for income, then even if you invest in longer-term funds because of the higher yield they provide, put some money aside in shorter-term funds for emergencies. But also look carefully at long-term total returns for the type of fund you are buying. Total returns for some of the more conservatively managed bond funds with intermediate maturities but low expense ratios have been just as high (and sometimes higher) than those of longer-term funds, with lower risk.

       Finding the Numbers
    One way to find out both the duration and the average weighted maturity of any bond fund is to telephone the toll-free number of the fund group or check out the fund’s Web site. The fund should be able to supply you with this information.

    Morningstar (www.morningstar.com) also supplies duration and average maturity for bond funds that it covers. Average maturity is also included in AAII’s annual The Individual Investor’s Guide to the Top Mutual Funds (www.aaii.com/store/mfunds.cfm).

    Popular Fund Categories

    In an article of this length, there is no space to discuss in detail the many types of bond funds available. But I would like to comment briefly on some of the more popular categories of bond funds.

    Municipal Bond Funds:
    Municipal bond funds invest in bonds that are exempt from federal taxes. In many states, they are also exempt from state taxes for bonds issued within the state of residence of the owner of the bonds.

    Municipal bond funds have been the bond funds most widely held by individual investors, and deservedly so. For investors in higher tax brackets, they have provided excellent returns overall for the past two decades. But you should be aware that by far the greatest number of municipal bond funds are long term. That means that they incur significant interest rate risk. Those of you who have grey hair may remember that interest rates on 30-year Treasury bonds reached a high of a about 15% in 1984; and on balance, interest rates have been declining in all sectors of the bond market, along with those of 30-year Treasuries, since 1984. As I write this, interest rates on 30-year Treasury bonds are close to a 20-year low, hovering at about 5.5%. That is simply another way of saying that investors in bond funds have been fortunate because since 1984, we have seen a major bull market in bonds.

    Note, however, that average annual returns mask a considerable amount of volatility. For example, both in 1994 and in 1999, long-term municipal bond funds suffered declines in net asset value varying from 10% to 20%. Moreover, current interest rates are low, compared to those that prevailed over the preceding decade. What that means is that total returns for the next decade cannot be expected to match those of the preceding decade. First of all, current interest rates are a lot lower. That means that distribution income will be lower. Also, when you look at total returns for the past decade, bear in mind that those returns include a significant chunk of capital gains, due to increases in net asset value from the beginning of the decade to the current time. If interest rates were to remain flat for the next few years, then that portion of total return will not be there. In that scenario, you would earn only the interest income. If interest rates rise from current levels, then total return would be less than distribution income, and depending on the extent of the rise in interest rates, total return might be negative.

    If you cannot afford to lose any of your principal investment, or if you do not want to incur any volatility in the net asset value of your funds, an alternative would be to invest in municipal bond funds with very short average weighted maturities—say, under five years. Vanguard and T. Rowe Price both have these types of municipal funds. Their yields are usually above those offered by money market funds, but the funds incur significantly lower interest rate risk, and consequently, lower volatility.

    “Junk” Bond Funds:
    These funds invest in bonds of corporations whose credit quality is below investment grade, close to default, or sometimes, in default. Because credit risk is high, these funds can quote and offer very high yields. But default risk is high. In fact, for this group of funds, credit risk, and not interest rate risk, is the major risk factor. Make no mistake about it: this is a risky group of funds. Yield is high because the risk of default of bonds in the portfolio is high.

    In spite of their riskiness, this category of funds continues to attract a large group of individual investors. As an investor, what you need to understand is that because these bond funds invest in the bonds of corporations that are in financial difficulty, junk bonds track the stock market as much as the bond market. Over the past three years, total returns for this group of funds has ranged from poor to very poor. In prior periods, however, total returns were quite high, in fact, the highest of any group of bond funds, on average. This led many financial advisers to recommend junk bond funds as investment choices for almost anyone. This is unfortunate. These funds are a perfect illustration of the fact that high yield does not translate into high total returns. In spite of extremely high yields, some junk bond funds have lost up to 50% of their value in a number of years. Note, also, that total returns for this group of funds vary enormously from fund to fund.

    Junk bond funds should be considered highly speculative. Only buy bond funds investing in junk bonds if you have a very large, highly diversified portfolio. Don’t invest any money in junk bond funds that you cannot afford to lose.

    GNMA Funds:
    This is another very popular group of taxable bond funds, particularly among investors looking for high cash flow and income. These bond funds invest in mortgages that are guaranteed by the Government National Mortgage Authority (GNMA). Credit quality is very high.

    High credit quality, however, does not exempt GNMA funds from interest rate risk. In fact, GNMA funds have one unique risk factor: prepayment risk; that is, the risk that homeowners will refinance mortgages when interest rates drop.

    Total return for funds investing in GNMAs has been high, but not uniquely so. However, because GNMA securities are highly complex, if you want to invest in GNMAs, funds represent a more attractive alternative than individual GNMA securities.

    Which Should I Buy?

    Should I buy a fund or individual bonds?

    This question is hotly debated; but it does not have a single correct answer. A case can be made for investing in individual bonds or for investing in bond funds. Some individuals feel more comfortable buying individual bonds. Others prefer bond funds. Each has advantages and disadvantages. Direct comparison between funds and individual securities is, at best, imprecise.

    For example, will you earn a higher return by investing in individual bonds, or in a bond fund investing in securities with similar maturities?

    Most brokers would tell you that you will earn more by buying individual bonds. The broker will point out that a fund’s management expenses come directly out of your return. This is true, but incomplete. If you are buying one or a few bonds, credit safety becomes paramount. You do not want to own the one bond that defaults. So you buy high quality credits, even though by doing that, you are sacrificing yield. If, on the other hand, you are buying a bond fund, you can safely invest in a fund with somewhat lower quality credits without impairing credit safety, because the fund is broadly diversified.

    On a total return basis, for investors who buy and hold over long periods of time (more than five years), and who reinvest distributions, certain features of funds boost their returns when compared to individual securities. Any large fund can buy securities more cheaply than any individual. Also, bond mutual funds make distributions monthly. This is an advantage both if you rely on distribution checks for income and if you reinvest. More frequent compounding also boosts return. So does reinvesting at higher than money market rates. The higher reinvestment rate and monthly compounding of higher yielding bond funds boost total return over long holding periods. Over very long holding periods (10 years or longer), bear in mind that interest income and interest-on-interest comprise the greatest part of total return. On the other hand, if you buy a fund with a large expense ratio, or high commission costs, then this reduces total return.

    Funds offer a number of advantages compared to individual securities:

    • They enable an investor to buy a diversified portfolio cheaply and efficiently.
    • They are convenient—they simplify collecting and reinvesting distributions, as well as record-keeping.
    • They offer liquidity—if you want to resell, you always have a ready buyer.
    As a rule, if you are investing less than $100,000 (total) in bonds, and if you are buying securities other than Treasuries, then you might feel more comfortable buying mutual funds rather than individual securities.

    If your portfolio is larger, and if you are able to buy individual securities at a good price (without excessive commissions), then individual securities may be a better option, particularly if you prefer to buy and hold rather than to trade.

    If you are investing any amount in bonds, whether $5,000 or $1 million, and if you do not want to take any risk, then buy two- to five-year Treasuries through Treasury Direct [for more on Treasury Direct, see “Investing in U.S. Treasuries and the Treasury Direct Program,” by Annette Thau, in the April 2002 issue of the AAII Journal, available at AAII.com]. You eliminate credit risk and all expenses of buying and maintaining bonds in a bond fund. You will earn a yield significantly in excess of those offered by money market funds. And because maturities are short, you can buy and hold bonds to maturity, therefore ensuring that you never lose principal.

    Even if you feel comfortable buying some individual securities, you may want to include bond funds in your portfolio in order to diversify core holdings. Also, if you want to invest in bonds that require a lot of expertise, then it makes sense to invest in those through funds. As a rule, the greater the expertise required to navigate within certain sectors of the bond market, the better off you would be choosing a fund, as opposed to individual securities. If you want to invest in junk bonds, or in any international bonds (whether high quality or emerging market debt), then do so through a mutual fund. Due to the unique nature of the cash flows of mortgage-backed securities, and the complex features of corporate bonds, it is also simpler to invest in those through bond funds.

    One more note of caution needs to be added concerning bond funds. Don’t expect bond funds, even if they are conservatively managed, to outperform significantly the sector of the bond market in which they are invested. If, for example, interest rates on long-term municipal bonds go up from 5% to 7%, even the best managed, highest-quality bond funds with the lowest expense ratios will decline in value. This is not meant as a criticism of funds, nor does it lessen their usefulness to individual investors. It means only that individuals should realize that performance of bond funds will in all likelihood track that of the sector of the bond market in which they invest.

    Summary

    Here are some general principles that should guide the purchase of bond funds:

    • As a first cut, when investing new money in bond funds, look for no-load funds with low expense ratios and no 12b-1 charges. Focus primarily on funds that invest in high-quality bonds. The low-cost leader is Vanguard, with expense ratios varying between 18 and 30 basis points. T. Rowe Price and Fidelity also cap the expenses of some of their bond funds at 50 basis points.

    • When researching funds, distinguish between yield and total return. Be sure to compare total returns for exactly the same periods. Also, be aware that returns vary from fund group to fund group. For example, total returns for conservatively managed intermediate bond funds are sometimes higher than those of longer-term funds, with less risk. Also, now that bond funds have been around for long periods of time, examine average returns over a period of at least five years.

    • Don’t buy any fund whose share price fluctuates a lot if you are going to need the money in less than two years: you cannot know at what price you will be able to sell your shares.

    • If you are investing primarily for “income,” and safety of principal is important to you, don’t buy the longest-term funds or those with the highest stated yields. Those will be the riskiest funds. Instead, stick to funds that have intermediate (or shorter) maturities (whether taxable or tax-exempt) and that invest in high-quality bonds.

    • Before buying a fund, make sure you know exactly what securities are in it; check the current average weighted maturity or, better still, the current duration of the fund.

    • Don’t invest more than 20% of your bond portfolio in any bond fund that is long term, international or junk, and only invest in these funds if you have a large, well-diversified bond or bond fund portfolio (minimum: $200,000). It’s not necessary to own one of each.

    • The more complex the security and the more expertise it requires, the more appropriate it becomes to buy a fund rather than individual securities. Mutual funds are the most efficient way for individual investors to own international bonds, GNMAs, junk bonds and corporate bonds.

    • Taxable bond funds are appropriate for tax-deferred (or tax-sheltered) monies that you want to place in fixed-income securities. For those purposes, consider high-quality corporate, GNMA, or zero-coupon bond funds. For money that is not in tax-deferred or tax-advantaged accounts, do the arithmetic to determine whether taxable or tax-exempt bond funds will result in the highest net aftertax yield.


    Annette Thau, Ph.D., is author of “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds and More,” (copyright 2001, published by McGraw-Hill; $29.95). The book provides extensive coverage of bond fund investing. Ms. Thau is a former municipal bond analyst for Chase Manhattan Bank. She also until recently was a visiting scholar at the Columbia University Graduate School of Business.


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