BOND FUNDS - Have another look

When it comes to buying bonds, or bond funds, a lot of people wonder why anyone would pay to invest in them. They tend to think along the following lines; “Hey, I am already purchasing the most conservative investment out there, do I really need to diversify?”

Whether you need to diversify anymore or not is up to you, but don’t think that just because you have bonds you’re not going to see any change in their value. Bonds are of course interest rate sensitive, especially long bonds. The longer your money is tied up the more at risk you are. Now having said that, purchasing bonds backed by the full faith and credit of the US government is pretty darn safe, interest rate risks or not.

So what are the risks to owning bonds anyway? The most common risk associated with bond investing is interest rate risk. I’ll say it again, the longer your money is tied up, the longer you are exposed to that risk. You might wonder if holding the bonds until they become due eliminates interest rate risk. That is how it seems at first glance, but you are still exposed to interest rate risk when you hold the bonds till maturity.

As long as your money is tied up in long bonds how can you take advantage of today’s much higher interest rate? And I don’t mean today, as it Nov 2009, just today in general terms. If for example you have fifty thousand dollars in a bond paying 6%, but at some point rates hit 7.5% the only way you can take advantage of the new higher rates is to sell your long bonds. You can do that of course, but the price of your bonds with the lower interest rate will have plummeted. So there’s no getting around some risk, however safe from default your bonds are.

So let’s talk about risk of default. In the period of 1981 – 2000, the chance that the lowest grade of investment grade bonds (BBB) will default was 0.22% If you buy AA or AAA insured bonds you can almost say never, when it comes to defaults.

Let’s talk about the word default. When thinking of bonds it sounds awful. How many of you know what constitutes as default? Most people assume that when an issuer defaults its investors have been hung out to dry and will never get their money back. That is just about as far from reality as you can get. An issuer can be six days late on one interest payment and it will be declared to be in default. Of course there can be some serious consequences for the issuer that defaults, especially if he was planning on selling long bonds to cover the short term ones coming due soon. As a result of the default the ratings are going to change and that will make the issuer have to offer a higher rate to attract investors for their new bond issue; the one to pay off the other bonds.

A potential advantage bond funds may have over the individual issues is their ability to make changes in their portfolio. As investors of bond funds we hope that through judicial trading our fund managers are going to beat single bond issues. When purchasing a bond fund you really need to take a careful look at the expenses involved as they will take a big bite out of your returns. So when you do buy a bond fund you want your net return to be greater than single bond issues of similar grade, if at all possible. If you like the performance take a look at the present managers. Are the guys that got those great returns over the last five years the same ones managing the portfolio now?

That is a very important thing to check into and is often forgotten by investors and brokers alike. If the fund suddenly has a new management team in place how are they going to replicate the returns you are looking for? If that were the case I would simply look elsewhere. You may also check on how often they turn over the portfolio. If a fund has a yearly turnover rate of 100% that means that they hold stocks less than a year. That also means that all that buying and selling that produces the high turnover is going to be costly. You can expect high expenses in those funds with high turnover, and that will take a bite out of your returns. That turnover also generates tax consequences, so if you get in at the wrong time you may be participating in the funds tax burden.

In conclusion, before buying your fund find out how it generates its returns. Look into the funds management and see if the same guys that got the last five years of stellar returns are back for more, or have another management team taken over? How much risk are the managers taking to get your great returns and how often do they turn over the portfolio? And if it’s a bond fund you are buying, what is the quality of the bonds? Are they allowed to dip into the high yield arena or do they have to stick with investment grade bonds? Are they getting great returns due to AAA bonds or BBB bonds? Have any bonds in their portfolio defaulted?

Do your homework, find out what makes your mutual fund tick and don’t just chase after returns.

Good luck investing and happy reading.