November 24, 2009
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The marketing claims of the mutual fund industry assert that bond funds are superior to individual bonds because they provide total return that includes income as well as capital appreciation. By adding bond funds to a diversified portfolio, academic studies claim that an investor’s risk is lowered to his or her risk tolerance.
Record inflows into longer-term bond funds in the last six months have provided investors purported relief from the near-zero returns in money market funds. While those inflows have contributed to market dislocations, helping drive municipal bond yields to record lows, do not mistake those inflows or rising prices for an endorsement of bond funds.
Bond funds are inferior to individual bonds, as those who are now buying bond funds may soon discover.
It is not possible to know the exact return you will receive on a bond fund because that return depends not only on future interest rates, but also on the characteristics of the fund – its expense ratio, trading costs, maturity and credit positioning, and its diversification. With an individual bond, you are at least assured of a specific cash flow if held to maturity and the return of your principal. The total return depends on the periodic reinvestment rate of the interest payments.
You need a less diversified portfolio if you invest in high-quality bonds. Go for quality, not quantity.
Bond funds do not have the same characteristics as individual bonds. Individual bonds pay the same amount of interest every six months through maturity, at which point they pay the face amount of the bond. If you hold individual bonds to maturity, you do not have to bet on the direction of interest rates because you will get back the face amount of the bonds when the bonds come due. You can also choose the quality of the bonds you purchase. If you decide to sell an individual bond before its due date, you may get more or less than you originally paid, depending on the level of interest rates at that time.
Understanding bond funds is more challenging than understanding individual bonds
Buying an individual bond is straightforward. The only cost you incur is embedded in the bid-ask spread, unless you purchase the bond through a broker who charges a commission. No other fees are incurred unless the bond is sold prior to maturity.By contrast, bond fund investors face a myriad of embedded costs and understanding those costs is a challenge. The fund may charge a one-time fee for purchasing or exiting the fund in addition to ongoing management, maintenance and administrative fees paid out to the funds’ investment advisor. There may be distribution or service (12b-1) fees. Funds also incur trading costs based on their turnover, which are not reflected in the expense ratio and are not usually reported. Funds may also impose a low balance fee if the account is below a specified amount. The ‘other expenses’ category includes custodial, legal and accounting fees, as well as securities transfer fees and other administrative expenses. The fund’s expense ratio that reflects most of these fees is usually fixed, so an investor can assume that the fund will annually take that percentage of the assets.
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