Bonds have been below the radar for several years now, so I was hesitant to write about the topic, which was covered in chapter seven of John Bogle’s book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.”
Nevertheless, I decided to go ahead given the recent rounds of interest rate increases by the Federal Reserve, and despite the now 20-year-old data in the book. While Bogle may not have updated the quantitative data in the second edition of his book, the underlying principles still hold. By understanding Bogle’s thinking, we improve our own thinking.
He said of this class of assets, “The rise and decline of the bond fund empire is one of the most captivating, yet untold, chapters in the annals of the mutual fund industry.” He also reminded readers that bond funds had been the mainstay of the mutual fund industry until 1986, when investors owned 60% more bond funds than equity funds.
And while the parallels with 2018 are far from definitive, 1986 marked the beginning of a long bull market, one that would last until the dot-com bust in 2000. In those 14 years, bonds fell in popularity as their returns faded in comparison to those of equity funds. Are we entering a similar zone now in late 2018?
Bogle wanted readers to know that costs matter, as they do with equity funds, a subject addressed in previous chapters. As he noted, “Over a recent five-year period, for example, the return of an average corporate bond fund lagged the return of the corporate bond market by an average of 1.5 percent per year.” (That recent five-year period was in the 1990s.)
Within that universe, he distinguished between no-load bond funds and funds that charged some sort of sales fees. The no-load funds lagged the corporate bond market by 1.3% while the load funds trailed by 1.8%. That raises the ongoing question of why investors continue to buy funds with sales charges. Bogle answered by citing another legendary fund manager, Peter Lynch, who wrote, “Peter’s Principle #5: There’s no point in paying Yo-Yo Ma to play the radio.” But apparently people do.
To illustrate his point, Bogle used a hypothetical Treasury note with a 5% yield. The net return, after a sales charge of 1.5%, would be 3.5%. Consequently, a manager would have to earn an extra 1.5% in absolute terms and 40% in relative terms to get back to 5%. And what are the odds a manager can boost a bond fund’s return by 40%? Very slight, of course. And if he or she could, what are the chances an investor could identify that manager in advance?
Bogle has often said costs matter, and he also wanted readers to know how much they matter for bond fund investors. In one representative sample of bond funds, he found a direct relationship between costs and returns in three of the four segments he examined. He said:
“The low-cost quartile outpaced the high-cost quartile by an amount very closely equivalent to the difference in expense ratios; that is, each quartile had about the same gross return, and costs accounted for substantially all of the return differences. In the fourth case, returns in the low-cost quartile ran only slightly above returns in the high-cost quartile, but the high-cost funds held portfolios that were significantly riskier in every respect.”
Risk, in this case, was based on three factors:
- Duration.
- Volatility.
- Portfolio quality (based on S&P ratings: AAA to BBB).
Bogle reported the lowest-cost group had the lowest duration, the lowest volatility and the highest quality. He added, “The lowest-cost group had not only the highest returns, but also the lowest risks. Bond fund investors simply cannot afford to ignore that message.”
In a second example, he looked at short-term U.S. government bond funds. Again, returns went up as costs went down. For this segment of the bond fund market, each 1.0% reduction in costs increased returns by 0.9%. For example, the high-cost funds had higher returns—6.1% versus the group average of 5.9% --but delivered only 4.5% after deducting costs of 1.6%.
The author distilled the issue down to this question: “Which would you rather have, managers who pick short-term government bonds for you and take 26 percent of what they earn, or managers who pick the same bonds and take 7 percent of the return for their efforts? In short, would you rather earn 93 percent or 74 percent of the market return?”
Again, the lowest-cost fund group not only delivered the highest net returns, but also assumed the lowest risk, as measured by duration and price volatility. As a corollary to that, Bogle argued that high-cost managers take on higher risks in a vain attempt to compete with lower-cost funds.
Would the same characteristics be present in intermediate-term U.S. government and GNMA (Government National Mortgage Association, or Ginnie Mae) funds? Yes, for this group, a 1% reduction in costs would increase returns by 1.1%. For Bogle, this emphasizes the point that costs and returns are “inextricably interlinked” for bond funds of all maturities.
Bogle also looked at corporate bond funds, specifically intermediate term bond funds, and found essentially the same results.
In each of the cases above, he had also compared the results with those of bond index funds and found the indexes generally performed as well as the lowest-cost bond funds in each category—because of their cost structure.
Bogle also wanted us to know that manager skill can have an effect, “there are indeed some skilled professional managers at work in bond funds. The best of them are competent, experienced, and wise in the ways in which the fixed-income markets work.” From this, he noted that finding low-cost funds with better-than-average management is an excellent combination.
And he found his wit again in noting that investors aren’t the only ones facing confusion on the sales-charge issue:
“A dispassionate observer of the passing parade of contradictions within these giant national brokerage firms would be mystified. On the third floor of their buildings (let’s call it the institutional trading floor), their bond traders are bickering over a tick (in the parlance of the trade, a tick is a percentage point on a $1,000 bond, or about 31 cents). The traders are prepared to commit mayhem for 1â„16 (two ticks), and to take out swords and pistols, ready to kill, for 1/8 (four ticks). Yet, on the first floor of the same building (call it the retail sales floor), their account executives seem able to utterly ignore the baneful impact of 32 ticks (one full percentage point)—or even 50 ticks (1.6 percentage points)—that are laid on their customers year after year.”
Summing up, bond mutual funds can have a place in the portfolios of investors, but to get the best results they should be low-cost funds. Bogle showed how low costs, especially the absence of sales charges, can deliver the highest returns. Note that the specific details about gains and losses may no longer apply, but all evidence points to the principles remaining the same.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
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