Many investors now have stopped buying individual stocks, in favor of mutual funds or ETFs that make it easier to be in the market. The same holds for investors who want bonds or bond effects in their portfolios.
Bond mutual funds get Marvin Appel’s attention in chapter five of "Higher Returns from Safe Investments Using Bonds, Stocks, and Options to Generate Lifetime Income".
To start, he suggested bond funds might be a good idea for those who are overwhelmed by the selection of so many different individual bonds. Too much choice is no choice at all in some cases. There are several factors to consider:
Transaction costs
With just one purchase, fund investors can buy into a broadly diversified portfolio of bonds. Buying individual bonds, on the other hand, means you must pay your broker a transaction fee for each one. In addition, investments in mutual funds and ETFs means getting the services of professional managers at a reasonable cost.
Turning to the exit side of investments, if you sell a bond back to a dealer before maturity, there will be a penalty of probably a couple of points, a fee that will cut deeply into the modest premium you’ve earned by holding the bond. Unless you buy a back-load fund (discussed later in this article), you can sell your mutual fund at no charge, greatly increasing your flexibility. Further, it makes no difference when selling a bond fund whether you are making a big or small transaction; every investor gets the same price.
Diversification
With the exception of those issued by federal governments, there is always a risk, usually remote, that the company or state/local government to which you are lending your money will default. To get around the potential loss of their income and principal, investors buy bonds from many different issuers, just as they do with stocks. For buyers of bond funds, the diversification issue is easily surmounted, by buying a fund that is made up of at least ten different issuers.
Bond fund expenses
While it’s almost always cheaper to buy a bond fund than individual bonds, you will still need to pay some fund company expenses. These are collectively referred to as the “expense ratio” and defines what percentage of your fund is going to these unavoidable fees. Unavoidable because funds must inevitably rack up some expenses for administration, paying the bond pickers and so on.
You do have to pay these expenses, but you can help yourself by shopping around for the best prices (lowest fees). Many fund families now offer expense ratios of less than 1%, sometimes even closer to zero than 1%. John Bogle of the Vanguard Group has long argued that the real key to investing success is keeping costs down.
Sales loads
In addition to management and administrative expenses, you sometimes will be asked to pay a sales commission on top of everything else. Appel wrote,
“Every mutual fund has an expense ratio, but many funds impose the additional, separate cost of a sales commission. Unlike the expense ratio, you can (and must) avoid paying sales charges, which are also called sales loads. These can amount to several percent of your investment.”
He offered this example:
- You have $10,000 to invest in a fund.
- You are charged an upfront sales fee of 3.5%, or $350.
- Your starting investment will then be $9,650 instead of $10,000.
Now $350 may not seem like much in the context of $10,000, however, that is $350 that will not compound within your portfolio. These “class A” shares (or units) from a commission broker can significantly reduce your ultimate earnings (class A shares from no-load fund companies and discount brokers, on the other hand, can be relatively inexpensive).
Appel dislikes even more the “class B” shares, which charge three-quarters of 1% every year. That comes directly out of your returns and is paid to the person or firm that sold you the funds. If you become aware of this fee only after you’ve bought, and decide to sell, you may be shocked. Since you are locked into these shares/units for up to seven years, you must pay what’s called a back-end sales charge.
For example, if you held a fund for two years and it has a seven-year lock-in, then you will be liable for a whopping charge when you sell. In this case it would be 0.75% x 5 years = 3.75% in a lump sum.
There are also “class C” shares, which Investopedia defines as, “Class C shares—C-shares for short—is a specific type of mutual fund share. It is characterized by having a level load that includes annual charges for fund marketing, distribution, and servicing, set at a fixed percentage. The investor pays this fee throughout the year.” Their charges are usually between next-to-nothing (class A shares) and class B shares.
According to the author, the “only way” you should buy bond funds is through a no-load fund company or through a discount broker, neither of which charges sales commissions.
Other expenses
Watch out, too, for funds that penalize you for selling your fund before some fixed period expires (similar to the class B shares described above). Appel offered the case of one fund that charges 2% to investors who sell within 90 days of the purchase date.
You might also be charged a transaction fee at a brokerage, whether or not it is a discount broker. This fee goes to the broker rather than the fund company, but many brokers do offer some or all their funds at no transaction cost at all. Diligent comparison shopping can help you reduce your costs and increase your capital.
No maturity date
This is the biggest drawback to bond mutual funds, according to Appel. Why does this matter? Because you do not know what your ending principal will be, unlike an individual bond. As we’ve seen, when you buy an individual bond the facts are right in front of you: The bond’s coupon rate, the number of years to maturity, etc.
Bond funds don’t work the same way, since none of their holdings are fixed. Fund managers are regularly buying and selling individual bonds more or less continually, leaving investors with a moving target.
How much interest is the bond fund paying?
Appel complains that many bond funds do not tell their investors how much the individual bonds are yielding. With a portfolio of individual bonds, you know the yield to maturity on the bonds individually and collectively.
Bond funds that do not provide the yield and expenses ratios are something of a black box, and you may be misled about the current yield (the amount of coupon interest received from the fund annually, divided by the value of the fund’s holdings).
What the author called the “gold standard” of yield reporting is the “SEC yield”, a reference to figures provided by the U.S. Security and Exchange Commission.
Appel concluded the chapter by summing up in these words:
“Carefully selected bond mutual funds can be valuable tools for you and are almost mandatory if you have less than $25,000 to invest in your bond portfolio. Bond mutual funds can also be desirable if you want the yield you can get from longer-term bonds but want the freedom to access some or all of your investment in the nearer term. But beware—most bond funds are not worth your trouble, especially those that come with an up-front or back-end sales load or funds with high-expense share classes such as class C shares.”
