Why You May Want to Pass on Investing in Bond Funds
While they appear to have some of the same positive characteristics of mutual funds: spreading risk through diversification and professional management, bond funds generally do not offer the key benefits that are characteristic of individual bonds. Most investors are attracted to bonds for two reasons: the preservation of capital if held to redemption, and to lock in a known, steady stream of income. Bond funds provide neither of these.
In My Opinion, here’s why:
A bond is a contract
like any other. It spells out the rights and obligations of the parties involved — in this case — the bond issuer and the bond holder. The issuer contractually promises the return of the principal on a specific date, and an annual stream of interest income at a particular rate. If the issuer defaults, the bond holder can seek recourse through the courts.
Bond fund shares are equities — ownership.
Like all business owners, one risks one’s investment capital for the potential greater return in the future. Equities do not involve contracts or guarantees regarding return of principal or fixed interest rates.
With these essential differences in mind, let’s look at how the two investment types compare when it comes to preservation of capital. When you buy a bond, the value (price) of the bond will fluctuate with the interest rate environment. But, you can ignore that fluctuation because you have the option of holding your bond until redemption (by call or maturity) when you will get back the face value of the bond, unless the bond defaults.
When you buy a bond fund, you are buying into a fund that lives on into perpetuity. There is no known end date when your principal will be returned to you. The fund is in the business of trading and managing an inventory of bonds and cash and possibly other financial derivatives. You are completely dependent upon the trading acumen of the fund’s managers and upon the interest rate environment returning the value of your shares back to their original price or higher. Thus, with bond funds, there is only a potential for preservation of capital.
Now let’s compare owning individual bonds and bond funds when it comes to locking in a known, steady stream of income.
When you buy a bond, the instant you pay for it you know the yield to call and maturity, and the annual current yield of your investment until the bond is redeemed. When you buy shares of a bond fund, there is a prevailing dividend payout rate, but there is no guarantee that this rate will continue. If rates fall in the bond market, it seems inevitable that there will be a cut in the dividend payout rate of your bond fund. As rates continue to fall in the interest rate market, so will the dividend payout rate of your bond fund. You do not lock in a yield to maturity. You do not lock in current yield.
There are additional risks and costs associated with bond funds that do not exist with bonds. For instance, you pick up “trading risk.” The managers of a bond fund are in the business of trading bonds and/or using derivatives strategies in an attempt to increase the total return of the bond fund. Sometimes the trading is not profitable and this poor trading performance is reflected in your share price. You also pick up annual management expenses which come out of the bond fund, and that is reflected in your share price.
Finally, in open-end bond funds, there may be a sudden and large amount of share redemptions such as we typically see following substantial market upheavals (1987, 2004, 2008). The bond fund managers MUST meet those requests for redemptions, and in order to do so, they may have to sell some of their inventory of bonds, very likely at a very disadvantageous time and price. The remaining bond fund holders may see the result of that “forced redemption” reflected in the lowered value of their shares. Closed-end bond funds take away the “forced redemption” risk but they do not take away any of the other risks associated with bond funds.
Am I a proponent of buying individual bond issues? Clearly. If you are seeking preservation of capital and a known income stream, buy bonds. If you are seeking potential growth and a decent dividend payout rate, invest in the stock market. But don’t be misled by thinking that you can get all the advantages of these diverse types of investments by buying bond funds!
One positive note on bond funds: Bond funds have low investor minimums which may help small investors achieve some diversification. However, this may also be accomplished through other investment alternatives. Bond funds also would not be as affected by call risk as individual bonds.