What is a bond mutual fund?
Bond mutual funds are mutual funds invested in fixed income instruments. Usually bond funds will focus on a particular segment of the market, such as short-term government bonds, high yield corporate bonds, municipal bonds, and so forth.
Low cost no-load bond mutual funds might make sense for many small investors. As with all mutual funds, you gain immediate diversification. This is especially important with corporate bonds, since there is some risk of default (missed payments). If a bond default occurs in a mutual fund, shareholders barely notice. If a default occurs among the few bonds that would be held in a small personal portfolio, the loss could be devastating.
Further, funds have the convenience of practically unlimited unit size. Bonds are usually bought in round amounts. Most have a face value of $1,000. To defray costs and obtain maximal yields, moreover, bonds are often bought in blocks of $5,000 or more. Meanwhile, most bond mutual funds allow incremental additions and withdrawals of practically any dollar amount.
However, once you have more than a critical minimum, perhaps $10,000 to $20,000, you may be better served owning CDs and bonds directly instead of bond funds.
Why you should avoid bond funds (once you can buy bonds)
Expenses
Bonds are purchased primarily for income. Fund expenses detract from that income. Many managed bond funds charge around 1% for management. These fees represent a substantial portion of the income earned on most fixed income instruments. Using low cost no-load bond funds can keep expenses low. Buying bonds directly can wipe them out.
Lack of maturity
When you buy a bond, assuming the issuer is financially sound, you will receive the face value (usually $1,000) of that bond at maturity. Your rate of return will be exactly equal to the yield-to-maturity you secured when you bought the bond. Whether interest rates go up or down, and regardless of other factors that affect market prices during the period of ownership, at maturity you will get the face amount.
When you buy bond mutual fund shares, the value of those shares will rise and fall in the opposite direction of interest rate moves. Share prices will also change due to events affecting issuers of bonds held in the fund. Any good news and marginally bad news can change prices a little; devastating news like bankruptcy can cause great damage. The bottom line: unlike bonds, bond funds present an unknown rate of return.
Figure 21-1 models the growth of $10,000 over a 20-year period with changing interest rates. Assume the rate on a 5-year bond starts at 4%, rises by 0.25% annually for five years, drops 0.25% annually for the following ten years, then rises again, returning to 4% in year 20. The individual bond line reflects the purchase of a 5-year bond at 4% with reinvestment of all proceeds – interest payments and maturing principal – into new 5-year bonds at the new “current” interest rate. The bond fund line reflects the purchase of shares of a mutual fund whose only assets are 5-year bonds bought under the same circumstances as the individual bond line. A fund expense ratio of 0.5% is assumed.
As seen in the graph, the drain of fees and price volatility cause the fund to generate about $2,300 less return – a sacrifice of 23% of the initial investment though invested in identical market circumstances.
Adverse behavior
Most investors follow the herd when there is widely broadcast news. Bad reports often lead to panic; popular trends often lead to hype. Mutual fund investors have been notoriously guilty of acting with the herd mentality. After price declines show up on statements investors often express their disappointment by liquidating their mutual fund shares. Conversely, when news arises about huge returns in a particular fund or market segment, many investors jump on board.
Mutual fund portfolio managers have to invest when deposits are received, and they must sell holdings when liquidations occur. Combining this fact with the herd mentality of shareholders, bond funds tend to add positions in times of lower yields and higher prices; they commonly have to sell after prices fall, when yields are higher. Buying high and selling low does not work well for anybody.
Unknown tax consequences
If you buy a bond, the tax consequences are known. Interest is taxed while the difference between the price paid and the amount received at maturity will either add to or be deducted from income.
When you buy mutual fund shares, your ultimate tax liability is uncertain. Future liquidations of fund shares will be executed at prices not yet know. You may have losses, reducing the benefit of interest earned; you may have gains which will be taxed. Meanwhile, during the period you hold fund shares, if the portfolio manager sells bonds at a gain or loss, those gains and losses will be passed on to you with tax consequences.
What you should do instead
Because of the negative attributes highlighted above, you should only invest in bond funds when forced by circumstance. For instance, many retirement plan platforms are comprised solely of mutual funds. Maybe a specific account does not have enough money to buy a decent yielding CD or bond. Whatever the limitation, minimize your expenses and select a fund comprised of bonds you would buy individually.
For the rest of your fixed income investing, buy bonds and CDs. Click here to learn about gainful suggestions for building a solid portfolio. Assuming you stick with securities from creditworthy issuers you will know the forthcoming rate of return of each position; a return unhindered by expense, undamaged by herd mentality, and uncomplicated by unforeseen tax consequences.