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Bond funds no panacea
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When investors get scared, they look for safe harbors. Many seek the safety of bonds and bond funds sound like the answer. But wait. Are bond funds safe? You be the judge.
Bond Basics
A bond is nothing more than an I.O.U. You lend some money to someone and they pay you interest on your money while they have it. After they are finished with it, they pay you back. When you own a bond you are loaning your money to a company. You know what interest rate they will pay you and when you will get paid back, That is a bond.
Bonds have two wonderful characteristics. First, they have a known interest rate. Second, they have a maturity date. That's the date that you get your money back. And those two elements of a bond are what make them safe. To know why, you need to understand the risks of owning a bond.
The first risk of a bond is that the "company" you loaned money to goes broke and can't pay you back. For that reason, if you are looking for a safe place to put some money you should consider only highly rated bonds. Those are offered by companies that are (supposedly) in good shape.
The next risk in a bond is that if you buy a bond today that is earning 4% interest, and next year interest rates rise to 5%, your bond will be worth less if you want or need to sell it before it matures. Why? Ask yourself: if you bould invest $1,000 and get a 4% bond or a 5% bond, all things being equal, which would you buy?
Notice that I wrote "if you want or need to sell it before it matures." If you simply hold the bond, you will continue to earn the stated interest rate and when it matures you will get all your investment back. That's why it's critically important to only buy bonds that you can reasonably expect to hold to maturity. So, if you're 65, you may want to steer clear of 20 and 30 year bonds.
So now that you have a basic understanding of bonds, what about bond funds? These are mutual funds that invest in bonds, so they must be safe too, right?
Not so fast.
When you buy a bond mutual fund you are not buying a bond. A bond mutual fund has no maturity date and no known interest rate. So what, you ask? If the value of bonds fall when interest rates rise, what will happen to the bonds in a bond fund? They will be worth less on paper. When investors see the value of their investments fall they have an uncanny habit of getting their money out. Since the bond fund needs to send them a check when they cash out, the bond manager will have to begin selling some of the bonds in the fund. When you sell a bond for less than you paid, you lock in that loss and there is no possibility of recouping your investment on that bond.
And where are interest rates today in a historical perspective, high or low? Most people would agree that they are very low. If interest rates are low now, you can probably agree that common sense tells you they may increase over the coming years. And if you fled to safety in a bond fund you may have committed the cardinal sin of investing: buying high and selling low.
There's one last issue with mutual funds of all types, not just bond mutual funds. They have fees that are called expense ratios. These fees are used to pay the manager to buy the right bonds. Bond mutual fund fees average less than 1%, much less at Vanguard. There are other fees on top of the one you can see known as transaction costs. The manager incurs a transaction cost whenever he or she buys or sells a bond in the fund. You might think they don't do much of that but you'd be very wrong. Bond funds trade bonds actively. And those transaction costs can easily add another 1% drag on your return. Think of it this way, if you buy a bond that has a 4% interest rate you get to keep it all. The same bond in a bond fund with a total of 1,5% in expenses will bring you a mere 2.5%
Are there advantages to bond funds? Yes. The big one is diversification. The fund will typically own hundreds of bonds so if one company goes broke and defaults on their bond it won't have much effect on you,. Many studies have shown though, that if you have 25 bonds in your own portfolio you have achieved virtually the same safety that you'd have in a bond fund.
So are bond funds safe? It all depends. But buying individual bonds is probably a lot safer and puts you in control of your money. And isn't that what you were looking for in the first place?
Direct questions, comments or suggestions Pete Winer at iampetew@yahoo.com
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