Investing in Bond Funds

“It’s important for investors to remember the reasons they own bonds in the first place – namely for the potential for the preservation of capital, income and growth, relative steadiness and typically low to negative correlations with equities. These needs – which will only become more urgent as millions of baby boomers head to retirement over the next decade and a half – are long term, regardless of what markets are doing today.” – Bill Gross

If you missed the first three posts in my common sense series on bonds be sure to read:

Part 1 – Investing in Bonds
Part 2 – Why Bother Investing in Bonds?
Part 3 – Bond Investment Risks

It makes sense to invest in stock index or mutual funds because they give you a broadly diversified portfolio of many stocks which reduces your risk of large losses from owning a single stock.

You also could incur large transaction costs by trying to implement an entire portfolio on your own.

The same rings true for bond investments.

Only with bonds it’s even harder to create a diversified portfolio using individual bonds on your own unless you (a) have a large amount of capital (typically bonds are sold in lots of $10,000 or $100,000) and (b) know how to trade bonds on the open market (transaction costs can be larger for bonds than stocks because of the spreads and lack of liquidity).

For these reasons and for the sake of simplicity, bond funds are the way to go for most individual investors as opposed to buying individual bonds.

INDIVIDUAL BONDS VS. BOND FUNDS
But there are some differences between bond funds and individual bonds that you should be aware of. As I have covered previously, when you own an individual bond, you invest for a set period of time and get paid interest for the duration or maturity length of the bond. Then the entire principal balance is repaid at maturity.

In theory, you could hold an individual bond to maturity and never lose any money even though the market value of the bond may fluctuate based on changing interest rates and other factors (but you could still lose out to inflation over time).

On the other hand, bond funds are generally considered to be constant maturity investment funds. That means that the maturity of a bond fund is the average of all of the individual bonds in the portfolio which stays fairly stable over time.

As older bonds mature, newer bonds are purchased and the portfolio manager of the fund generally tries to keep the average maturity in the range that is stated in the fund’s objective.

The NAV (net asset value) of a bond fund will move up or down based on a number of factors such as changes in interest rates, credit quality, and currency values (for international bonds) for the different bond holdings in the fund.

Bond funds work great for diversification purposes and for gaining exposure to a wide variety of markets, geographies and strategies at a low cost.

You can invest in bond funds by stated maturities (short-term, intermediate-term, long-term), credit quality (treasuries, junk bonds, investment grade corporate bonds) or pretty much any other way you can separate bond investments. This gives investors a lot of options for tailoring the bond portion of their portfolio to their specific needs and risk tolerance using various bond funds.

OBJECTIVE OF THE FUND
Make sure you understand the objective of the bond fund before making an investment. Are you looking for a high amount of income? Searching for safety? Trying to enhance returns? Saving for a specific goal?

Since not all bond funds are created equal you must make sure you understand the composition of the fund to make an informed decision.

That means looking at the fund’s objective, average maturity, credit quality, yield and the composition of the holdings by bond type.

For example, the Vanguard Total Bond Market ETF (ticker BND) is comprised of roughly 47% in government bonds, 27% in corporate bonds and 26% in mortgage bonds. The average maturity of the fund is 7.3 years but over 50% is less than 5 years while 15% or so of the fund is greater than 10 years. It yields just under 2.5% at the moment.

Also, over 70% of this fund is invested in Aaa-rated bonds (the highest credit rating available) which means that it is considered very high quality. You can use BND as the baseline in which to measure all other bonds funds you are looking at because it is used as a proxy for the entire U.S. bond market.

All else being equal, here are some general relationships to consider:

1. The higher the yield, the higher the risk and the higher the potential return.
2. The lower the yield, the lower the risk and the lower the potential return.
3. The lower the credit quality, the higher the risk and the higher the potential return.
4. The higher the credit quality, the lower the risk and the lower the potential return.
5. The longer the maturity, the higher the risk and the higher the potential return.
6. The shorter the maturity, the lower the risk and the lower the potential return.

The price you pay for an investment is the biggest determinant of the future performance so these relationships don’t always hold true exactly and there are many risk factors to consider.

There are far too many moving pieces in the markets that can make investments act irrationally. But, if you are comparing two similar bonds funds, these general rules should help you make an informed decision based on the factors that affect risk and reward.

WEAKNESSES
One of the areas of weakness when investing in bond funds when compared to individual bonds is when you are trying to save for specific goals based on a specific time horizon.

For example, let’s say you know for sure that you have to make your first college tuition payment in five years and would like to buy a relatively safe investment based on that time horizon. If you purchase an individual bond with a five year maturity you will receive interest payments for the term of the bond along with total principal repayment at maturity.

That means that the closer you get to paying that tuition payment, the safer you will feel knowing that your bond will come due at maturity and you will get your investment back in full including all interest payments over the life of the bond (assuming no default).

However, with a bond fund that has a constant average maturity of five years you will receive interest payments based on the average of the fund’s rates but as you get closer to your five year goal, the fund not necessarily be getting less risky.

You could potentially lose money in your bond fund depending on interest rate movements around the time you actually need to make your payments. That’s because bond funds don’t have a stated maturity date and will continue to keep updating the fund will newer bonds as earlier purchases mature.

If fund providers could combine lower costs and diversification with the ability to set a maturity date bond investors could better plan for the future and lower their risks.

TARGET DATE BOND FUNDS
Luckily, the asset management industry has recently come up with a solution for this problem by creating bond funds with a specific maturity date. Blackrock’s iShares unit recently came out with four ETFs that will focus on corporate bonds and have set maturity dates of 2016, 2018, 2020 and 2023.

Using these target dated funds would allow you to better plan for your short to intermediate term goals by having a set date that you can plan on having a return of your invested capital. They are still relatively new but I would expect them to gain in popularity, especially as more of the workforce enters into their retirement years.

Another way to get around this problem is by laddering your bond funds. So you could buy a mix of short-term and intermediate term bond funds to spread out your risk. Investors used to be able to do this with CDs but the rates are now so low that it doesn’t make sense to invest in them for longer periods of time (especially as rates rise).

In most cases, if you don’t have specific a time horizon for your goals, investing in diversified low-cost bond funds will do the trick. Obviously, there are many other goals and strategies to discuss when investing with bonds.

Bonds don’t sound too complex but the situation that we are currently in with very low interest rates makes things both interesting and challenging.

To go over some different scenarios for structuring your bonds investments, the next part in my common sense series on bonds will cover some other strategies you can use depending on your goals, risk profile and time horizon.

Sources:
iShares Debuts 4 Target Date Bond Funds
Vanguard Total Market Bond ETF (BND)

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