Bond Funds

The Popularity of Bond Funds

Bond funds, like investment funds in general, have really taken off in popularity in recent times. The idea behind investing in a fund is that the investor purchases shares in funds that provide much more buying power than the great majority of individual investors could ever dream of, which provides a lot more diversity than would otherwise be attainable.

This is really seen as an advantage for stock investors, who have been sold on the idea of wide diversification and are able to achieve however amount of diversification within an asset class or across asset classes if one wishes. There are certainly some benefits to this although they do tend to be well overstated.

If one invests in a handful of stocks, especially ones in the same sector, and this handful of stocks ends up doing poorly, and underperforms the market, this leads to an undesirable situation. If we instead spread our eggs across a lot of different baskets, we can hedge against these particular risks.

The same goals can be achievable with bond funds, where we can invest in funds that are very well diversified, containing hundreds or even thousands of different bonds with all forms and length.

Bond funds also provide management, where positions can be entered and exited and income from the funds can be professionally managed, taking all the work out of this for investors, who merely have to pony up and sit back and let others manage everything for them.

The Ease of Bond Funds

This is certainly seen as a benefit, but perhaps the biggest reason to invest in bond funds is that bonds aren’t really that accessible to individual investors like stocks are, because bonds aren’t traded on exchanges, and few people even have the means to manage even a modestly diversified bond portfolio due to lack of sufficient capital.

Bond funds make all of this not only completely accessible but super easy, allowing investors to enter and exit positions with bond funds with ease, and perhaps more importantly, set up an investment schedule where they can make regular contributions to the fund over time.

This is the biggest advantage that bond mutual funds have over any other form of bond investing. High minimums are going to preclude people from buying bonds this way otherwise, and especially if one is only looking to contribute a smaller amount per month to bonds.

If one looks to invest in a bond ETF, they will enjoy lower costs generally, but each trade has a commission attached and if one is investing regularly, these commissions and other trading costs can add up to a lot more than the difference between the management fees.

This is a big issue when we compare any mutual fund to any ETF, and this results in ETFs being more suitable for trading, where mutual funds tend to better suit a regular investment plan, ones that people use when saving for the long term, for retirement in particular.

With a bond mutual fund, you can simply provide instructions to have your bank account debited a certain amount per pay, or per month, and everything else is taken care of you. Mutual funds can certainly be a set and forget strategy of investing, and this is something a lot of investors find very appealing.

As long as the mutual fund is no load, which many today are, then there are no increased costs in continually loading it, allowing you to put your savings each month right into the fund, rather than having to set this aside and save up enough to make a contribution.

To do this yourself, to invest in individual bonds, it is recommended that investors have a minimum of $100,000 to put down initially, which is beyond the means of the majority of individual investors. With mutual fund bond funds, one can get started with as little as a few hundred dollars, and achieve much more diversification at the same time, as well has enjoying a fund that has been put together by professionals.

Management Fees with Bond Funds Are Significant Though

There is a price that you pay for all of this, and that price is extracted in management fees, typically ranging between 1 and 2 percent.

This does include all of your costs though with most funds, and if it doesn’t, then it makes sense to look elsewhere as it’s easy to find funds that just charge management fees and do not have other charges associated with them for just buying, holding, and selling shares in a fund.

Fees for managing a fund tend to be similar across asset classes, for instance comparing the fees for a bond fund versus a stock fund. Whether or not a fund is actively managed or not matters as well, but passively managed funds tend to outperform the actively managed ones overall, in terms of net returns, and are generally a better choice.

Let’s assume our bond fund is passively managed and has a nicely reasonable 1% management fee involved with it. We could choose a stock fund as well for similar fees, and we might think that the costs of the two are similar, because we’re paying the same amount of fees for each.

These fees can only properly be understood as a percentage of our expected return though. Bonds produce considerably lower returns on average than stocks do, and let’s say that this is halved on average, which makes the management fees twice as high relative to returns.

On top of this, yields on bonds do fluctuate according to interest rates, and in come cases we may expect that the yields may be pretty low when rates are low. This is the current environment that we’re in today, and there’s a big difference between getting a 5% return and paying 1% in fees with only getting 2% and giving up half of that to fees.

When we consider this, other means of investing such as certificates of deposit, which avoid management fees, are made more appealing due to their guaranteed returns as opposed to the riskier ones of bonds. If the returns of a bond fund less the management fees do not provide enough of a difference in return, then one may be better situated to invest in the safer option.

If we own the bonds ourselves, while there are always costs involved in investments, this can get rid of the need for these management fees, and we can enjoy significant savings here. We will have to give up a lot of diversity though, but is diversity really needed with bonds?

Diversity and the Goal of Bonds

The major goal of bonds is to provide a safer and more reliable component of our investment portfolios, where we’ll put a certain portion of it in bonds to diversify stock holdings, or even to put it all in bonds if we are looking to avoid the particular risks of stocks due to their higher volatility.

Bonds pay out a certain amount of interest according to the risk involved, where safer ones, such as U.S. treasuries, pay less but are safer, and on the other end of the spectrum, junk bonds pay a lot more but have a lot more risk.

Stocks can also be riskier or less risky but this is not built into their purchase, for instance buying $10,000 of a safe stock and a risky stock will still cost you $10,000.

Therefore, there can be a need to hedge stock positions as hedging is not priced into them in the same way that they are priced into bonds. While the riskier types of bonds may and do often require hedging, the safer ones do not, and if you own the safest ones, there really isn’t a bond you can hedge the risk with anyway.

Bonds tend to move together, at least as far as their sensitivity to interest rates go, and hedging against default risk can be best achieved by not diversifying but instead by concentrating on those with the lowest risk.

If one seeks out bonds to diversify their positions in the stock market, it’s actually best to focus on what will provide the best hedge here, and that turns out to be investing in top quality bonds. If one has a limited amount to invest, treasury bills can be invested in for as little as $100, and this is very often the best strategy for small and larger individual investors alike.

The goal here is of course to look to protect one’s positions and while holding a certain amount in cash would do that as well, the highest quality bond investments provide all the safety of cash while providing better returns.

Should we desire a better rate of return with our hedges, we can simply allocate more of the money we are looking to hedge with in bonds to our stock holdings. If we are really looking to take on more risk with some of this money, we may be better off taking on this risk in the stock market rather than investing in riskier bonds.

Stocks tend to return more and may even have a better risk to reward ratio than riskier bonds, but the main reason to consider this is to look to avoid paying management fees on the bond component of your portfolio, if we can manage to do this.

This is not to say that bond funds are a bad idea in some cases, but we at least need to look at the costs and benefits of alternatives, including looking to own and manage our own bond holdings.

Bonds aren’t even the best way to hedge stocks, as there are more efficient means of doing so within the asset class of stocks, and the best way to hedge a position within an asset class is to hedge it with the same asset class, which provides a direct relationship.

The best way to do this is to manage one’s positions according to market conditions, to move money in and out of positions and even look to take advantage of market downturns if one is up for that, although all of this does require a certain amount of skill and dedication which is beyond the interests of the great majority of investors.

Other than that, offsetting these risks by investing in less volatile instruments can certainly help, and bonds do provide that benefit. Whether or not we want to invest in bonds directly, take positions in bond ETFs, or invest over time in bond mutual funds will come down to the means and desires of the investor.

However, we should never just go with one strategy because it is popular or sold to us, and in spite of whatever our inclinations are, we at least owe it to ourselves to explore the alternatives and come to whatever decision we make by way of deliberation and not just impulse.