Bond Funds Vs. Bonds


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Bond investors can build portfolios bond by bond or they can opt for a mutual bond fund. Which approach is likely to produce a better outcome? Answering this question is not as simple as you might think. Fortunately, it can be addressed with facts and figures, which I prefer to abstract theory and biased marketing claims.

On June 5, Bankrate published a list of “best bond funds for retirement investors.” The table below compares them with appropriate indexes on the basis of yield and total return. (The latter takes into account income, price change and reinvestment of income). I collected the yields on June 5 and measured the returns for the five years ending on that date.

All seven funds emphasize investment grade bonds—mainly governments and corporates. Five have no restrictions on bond maturities and two own only bonds maturing within five years. The reference indexes with which I compare the funds’ returns are listed in the table. (Note that they are not necessarily the same benchmarks employed by the funds in reporting their performance.) If a fund’s yield exceeded its reference index’s yield or if its return in a given period exceeded its reference index’s return, the relevant percentage is shaded.

With only seven funds covered in our analysis, we cannot test rigorously for statistical significance. Still, we believe the exercise is useful to most individual investors. If a reputable source provides a short list of “best” funds, investors are more likely to pick one from that list than to investigate dozens of possible choices that no experts have vetted.

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Key Findings Of Yield And Return Comparison

Yield And Relative Performance

Only one fund in each category outperformed its reference index over the full five-year period. (See last column to the right.) Those two outperformers were also the only two that currently offer higher yields than their respective reference indexes. Note that Fund G focuses on floating-rate rather than fixed-rate bonds, which can provide an edge when interest rates rise sharply.

The two outperformers also had the highest expense ratios among the seven funds—0.45% for Fund D and 0.15% for Fund G. Expense ratios for the other funds ranged from 0.04% to 0.025%. Note, however, that the returns shown in the table are after deduction of expenses.

What do we learn from these findings? Suppose you expect that if you create a self-managed investment grade bond portfolio, your return will be no better than average, that is, in line with the appropriate investment grade benchmark. You may be able to improve on that outcome by owning a professionally managed mutual fund.

Based on the evidence presented in the table for one specific five-year period, concentrating in bonds with fatter yields provides a fund manager some advantage in striving for a superior total return. That relationship is not as obvious as it might seem. Holding factors such as coupon and maturity constant, Bond X with a higher yield than Bond Y carries greater credit risk than Bond Y. In a period of economic decline, Bond Y may experience less price deterioration than Bond X and therefore post a higher total return.

Be aware, however, that maximizing yield can lead to erratic performance. An investment grade fund manager may pump up the fund’s yield by “going outside the box.” That phrase refers to using the latitude in the fund’s investment guidelines to invest some assets in speculative grade (also known as “high yield,” or more pejoratively, “junk”) bonds. The greater credit risk in those securities will tend to boost performance during bull markets for credit-sensitive assets but penalize it during bear markets.

Performance in Good And Bad Markets

Both the general bond index and the five-years-and-shorter index recorded their highest full-year returns of the period in 2019. In that year, only one of the seven funds outperformed its reference index. Similarly, in the second-highest total return year, 2020, just one fund outperformed. In sharp contrast, all seven funds beat their reference indexes in the worst year. That was 2022, when the ICE BofA U.S. Corporate & Government Index posted by far its lowest total return, -13.75%, in its 51-year history. (To put that number in perspective, the general bond index’s second lowest total return was -3.27% in 1994.)

As interest rates soared, the bond funds covered in our study cushioned the downside to some extent. (The ICE BofA U.S. Corporate & Government Index’s yield nearly tripled from 1.66% to 4.65% in 2022.) Note that Fund G, the one that concentrates on floating-rate bonds, managed to register a positive return, 1.28%, despite the brutal environment. The other six funds’ cushioning of the downside in 2022—less than one percentage point in the context of 13.75% and -6.10% returns for the two reference indexes—came at some cost to performance in the best years.

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The Do-It-Yourself Alternative

In principle, it is not difficult to replicate the less downside/less upside trait documented in the preceding paragraph. Seemingly, you just need to create a portfolio somewhat less risky than the index that represents your desired maturity and quality mix. To dial down interest rate risk, maintain a shorter average maturity; to limit credit risk, maintain a higher average credit rating.

If you do choose to self-manage your bond holdings, however, be prepared for some practical challenges. For one thing, the average maturity of your portfolio shortens as the bonds in it age. To maintain your desired average maturity, you must either replace current holdings with longer-dated issues or add longer-dated issues to your existing portfolio.

Similarly, the credit ratings on bonds within your portfolio can change. If a bond’s rating declines, it means that the bond has become riskier, reducing your downside cushion in an economic downturn. If the rating rises, it means the bond has become less risky, which cuts into your upside in an improving economy.

A major decline in a bond’s credit quality can cause its price to fall sharply. If you decide to sell it at that point, seeing a possibility of further deterioration, you will have less capital to invest in the replacement bond than you originally put into the one you are selling. You will have incurred a permanent loss.

So will any mutual fund that held the downgraded bond, but there is a difference. If you own just a handful of bonds, with each representing 5% or 10% of your total portfolio value, that one loss can materially affect your overall return. Bond funds are in a different position because they are widely diversified. As of June 2023, some of the funds shown in the table above had less than 1% of their portfolio in any single bond.

One way to protect against high-impact credit quality declines is to monitor closely the fundamentals of each bond you own. Even then, a company represented in your portfolio may experience a genuinely unforeseeable credit shock, such as the loss of a major customer or an environmental disaster.

Alternatively, you can become more like a mutual fund and spread your bond holdings over so many issuers that none represents more than, say, 2% of your portfolio value. That approach, though, may impose a larger monitoring workload than you are willing to shoulder.

These considerations highlight a bond fund’s advantages over direct bond ownership. Funds can also have disadvantages, however. Suppose you own a high-quality bond that falls from 100 to 90 in response to a rise in interest rates. If you hold on, then barring a default by the issuer, your bond will eventually be redeemed at maturity at 100. Now suppose that same bond is held by an intermediate bond fund that owns only bonds maturing in five to ten years. Once the bond gets to within five years of its maturity date, the fund will have to sell it at a loss and replace it with one in its permitted remaining-maturity range. If you own shares of the fund, you will incur permanent losses on all bonds that are depressed as a consequence of the interest rate rise and coming within five years of maturity.

As an alternative to widely diversifying like a mutual fund, you can concentrate your self-managed holdings in your highest-conviction picks. It is mathematically possible, at least, to beat the index, since roughly half of the index’s produce higher-than-average returns. Your challenge is to select bonds that are destined for the better-than-average category.

Here are some numbers that provide a flavor for the potential rewards of astute bond selection. In May 2023 the ICE BofA U.S. Corporate & Government Index had an average rating of mid-AA and an average maturity of nine years. Eight bonds in the index had both of those characteristics. Their average return for May 2023 was -1.11%, but the range was -1.73% to 0.25%.

If you believe you can predict which bonds will be superior performers, then self-managing your portfolio, rather than investing in funds, will be your preferred approach.

With inflation running at 4.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.

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Nicole Lambert
Nicole Lambert
Nicole Lamber is a news writer for LinkDaddy News. She writes about arts, entertainment, lifestyle, and home news. Nicole has been a journalist for years and loves to write about what's going on in the world.

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