LET'S FACE IT. The easiest way to invest in bonds is to buy a bond mutual fund. Financial firms have catered to this strategy by creating almost 3,000 such funds and packaging them in a variety of shapes, structures, and contents. But holding an individual bond differs greatly from owning a bond fund because the fund has no due date. "A bond mutual fund is not by definition a fixed-income product," says Cort Smith, senior editor of Investment Adviser.
As we described in chapter 5, fixed-income investments calculate the compounding yield-to-maturity and worst-call yield, referred to as "yield." Funds cannot use those yield calculations so the meaning of the word yield is different when it's applied to them. Fund yields are a good measure of their income-generating potential, more like a current yield for individual bonds.
Although many view competition as a good thing (actually, we do, too), when it comes to funds, it isn't. The tremendous number of funds competing for your attention and dollars has created a severe case of obfuscation. Until 2002, this situation was further compounded by the fact that only 65 percent of a bond fund had to consist of the kind of bonds described in the title of the fund. That changed when the SEC mandated that 80 percent of the securities in a fund must be within the parameters set by the fund name as of July 31, 2002. That still leaves 20 percent of fund assets to be invested either in cash for redemptions or in more lucrative and risky securities in an attempt to goose up yields. In other words, if it says it's a Treasury bond fund, it must be a Treasury bond fund, mostly.
What remains unchanged is that trying to classify and categorize bond funds is a daunting task. Let's first review the characteristics common to all funds. No matter what the size or purpose, every bond fund has a per-share net asset value (NAV). This is the measure by which funds are valued daily. It is calculated by dividing the sum of the values, reduced by any liabilities, of all the bonds in a portfolio by the number of shares outstanding. All funds also provide a figure known as total return. This consists of a fund's cash distributions, plus or minus any change in share price during a specified period.
The NAV drops after a fund pays out the required 90 percent or more of its realized capital gains and dividends, usually in December, to reflect the lower fund value. You pay taxes on the distribution whether you owned the fund one day or one year. Before you invest, it's a good idea to find out when the fund generally makes this distribution.
Since funds are pass-through entities for tax purposes, if you hold shares of a taxable bond fund outside of a retirement account, you must report your share of the fund's interest income minus the fund's expenses. In addition, if the fund has realized capital gains, you must report your share of capital gains annually, whether the fund pays it out to you or reinvests it. If the fund has losses, they will offset the gains recognized by the fund. However, for tax purposes, if a fund has net capital losses, these capital losses may not pass through to its shareholders.
Unlike bonds, which have specific due dates, bond funds are described, as required by the SEC, in terms of their approximate maturity. All funds have dollar-weighted averages that reflect their stated maturities. Money market funds, which are almost cash equivalents, have maturities of one year or less. Funds with maturities of less than three years are short term. Although the SEC does not define the word "limited," it is usually applied to funds with maturities that fall between short and intermediate, generally less than five years. Intermediate funds are those with average maturities of three to ten years, and long-term funds are all those with maturities of ten or more years. The majority of bond funds are long term. Because there is no fixed maturity date for bond funds, they are missing the key characteristic that distinguishes an individual bond. Bonds come due, bond funds do not, although the bonds within the fund do come due. If you purchase a bond maturing in three years, you know you will get the face value of the bond back in three years. If you purchase a short-term bond fund, you don't know what your shares will be worth in three years. They may be worth more or they may be worth less.
A general rule is that the longer the maturity, the higher the yield and the greater the fund's price fluctuation. That's not to say that short-term rates don't fluctuate. The Federal Reserve Board cut short-term rates eleven times between 1999 and 2002, and raised them fourteen times between May 2005 and December 2006. The difference is that the bonds in short-term funds come due quickly, and new ones are bought at the prevailing rates. If new money is flooding into a fund, it helps a fund mirror the going rate for bonds so the yield adjusts rather quickly on the upside or downside.
Because bonds in a fund do not all mature at the same time and bonds in many funds are replaced when they no longer are within the fund's investment parameters, the concept of yield-to-maturity is not applicable. Instead, the SEC has mandated a seven-day yield calculation specifically for money market funds in addition to a thirty-day yield calculation required for all funds, including money market funds. The SEC-mandated yields are standardized calculations that are the same for all funds. They allow you to compare returns after fees and expenses. These yields are not comparable to the compound yields on individual bonds.
In addition, an SEC rule that took effect in February 2002 requires all mutual funds, bond and stock alike, to calculate their returns on an after-tax basis. Because so many factors go into an after-tax calculation, the SEC mandated a uniform approach that uses the highest federal tax bracket (35 percent in 2006). The SEC rule also requires that any loads be subtracted from the after-tax return. This calculation is a useful tool for comparing one fund to another. It appears in each fund's prospectus and advertising material that touts tax efficiency.
The advertised yield on a bond fund can and will change over time. The yield you expect to get will not necessarily be sustained. You can get some indication of how much money your fund will earn over the course of a year by looking at the twelve-month distribution yield. This yield is the sum of all dividends paid over a period of time divided by the ending price. This return is comparable to a current yield on bonds and includes a payout of both principal and interest. There are likely to be disparities between the thirty-day and twelve-month yield calculation because of changes in the composition of the fund over time, and the distribution yield does not back out expenses.
To supplement the notion of maturity, an often-used indicator in fund analysis for bonds is duration, a predictor of the volatility of a fund's NAV that reflects the bond's sensitivity to interest-rate changes. In the event that interest rates rise, duration gives a measure of how much the fund will lose in value. The fund's duration is usually permitted to fluctuate between 95 percent and 105 percent of the duration of its benchmark, as the manager makes adjustments to the portfolio.
The longer the average maturity of a bond fund, the greater the price sensitivity it will have to interest-rate shifts. However, in general, the more extended the maturities, the greater the interest payments into the fund, which cushions the market fluctuations.
Unlike individual bonds, funds do not have a maturity. For that reason, the concept of duration is used instead to compare funds. You might be asked: "Do you want to purchase a fund with a longer duration with a higher yield or one with a shorter duration and less volatility?"
The problem with using duration as a measure to compare funds of similar maturities is that each individual bond has its own duration and will act slightly differently when interest rates change, whereas the fund has a composite duration. Funds that appear to have comparable durations will suddenly start behaving differently when interest rates shift. Thus, sometimes people purchase ultrashort bond funds that have very short durations when the money market yields are low, only to find that they have much more market volatility than a money market fund because of a different portfolio construction. For this reason, investing in an ultrashort bond fund is not as useful a tool as it might appear.
Derivatives are becoming more commonplace in the bond fund world. They're used to manage all kinds of risks and sometimes to speculate as well. A derivative is an investment that is based on, or derived from, some underlying security, currency, or index. One example of a derivative transaction is an agreement between two parties to exchange a fixed-rate security for a variable-rate security within a set period of time, based on an agreed formula. Derivatives may be used as a hedge against interest-rate fluctuations, to protect against credit erosion, or to make a bet in order to increase the returns of the fund. Examine the prospectus or the statement of additional information to learn about a fund's use of this tool.
Bond funds tend to offer the following advantages:
Income. Regular monthly income with interest and principal payments made as dividend distributions. Individual bonds usually offer semiannual payments, though some pay monthly.
Reinvestment. Automatic reinvestment of income. Be aware, however, that this advantage is reduced if the fund charges a fee for the reinvestment.
Diversification. Should one bond in a fund default, the others will supposedly smooth out any disaster ripples. You can choose to purchase bonds of the highest credit quality, like a Treasury bond, with minimum diversification required, or purchase more investment-grade bonds of lower quality in smaller amounts. If you invest in high-yielding bonds with poor credit quality, purchase them through a fund.
Daily liquidity. A simple phone call translates into a sale posted at day's end; some funds offer free check writing on the accounts.
Bookkeeping services. Funds keep track of all your purchases and redemptions and report to you and to the Internal Revenue Service.
Professional management. Many bonds are difficult to evaluate. Foreign bonds and complex mortgage securities are best purchased through a fund.
Bond funds generally feature the following disadvantages:
Lack of fixed maturity date. An individual bond always provides a due date on which you will receive all your money back, but a bond fund almost never does; in other words, bonds come due, bond funds don't.
Lack of income guarantee. With an individual bond, the payment schedule is fixed, whereas payments from the various bonds in a fund can vary.
Capital gains tax. You have to pay tax on capital gains realized by the fund. Funds generate capital gains when they sell bonds to raise cash for redemptions or trade securities. Funds that have a high turnover rate, a measure of annual portfolio change, are said to be tax inefficient when they generate capital gains, because the gains are passed through to the shareholders. Funds can't pass through tax losses.
Susceptibility to market risk. Even conservative Treasury bond funds are subject to market risk. For example, BusinessWeek warns: "If the yield on a 10-year Treasury jumps by half a percentage point from 5 percent now, it will lose about 10 percent of its market value."[118] That means that even the bond fund holding the safest securities could still experience a market decline that may continue for many years.
Checking the Costs: Hidden and Unhidden
Management and other fees are another constant among all bond funds. After all, these funds are created for management's benefit and not necessarily for yours. Therefore, it's important for investors to review this feature of bond funds thoroughly.
The largest and most blatant cost is referred to as the load. In effect, this is the sales commission earned by the person who sells you the fund. Funds that have such sales commissions are known as load funds. With these funds, you generally lose money right from the start because the load is deducted from the amount of money you initially invest. Critical comments about front-end loads, as they're called, have led fund companies sometimes to allocate the loads over a number of years or to tack them on at the end. Go to www.sec.gov/answers/mffees.htm for a complete discussion of fees.
Fierce competition among funds has reduced load amounts over the years. Whereas once they were frequently as high as 8 percent, 4 percent to 5 percent figures are more typical now. In an effort to reap commission riches and still be competitive, some funds have introduced smaller loads, with assessments ranging from 1.5 percent to 3.5 percent of the initial investment. These funds are known as low-load funds.
And then there are the funds known as no-load funds, which are without commission charges. Because there are no commissions involved with their sale, these funds must be bought. That is, you must seek them out rather than expecting a salesperson to offer them to you. Fortunately, they are easy to find because they advertise extensively.
Other costs, decidedly camouflaged, include back-end loads (yup—some funds charge you to get out of them); annual management fees to cover administrative expenses; advertising fees on the no-load and load funds (they're officially designated as 12b-1 fees); plus all the transaction fees that the fund pays when it buys and sells the bonds in its portfolio. And there are more: some funds have loads on reinvested dividends, exchange fees if you want to transfer from one fund to another, frequent transaction charges, and shareholder accounting costs.
These fees add up. Vanguard, the giant mutual funds organization and pioneer in no-load funds, capitalized on this in one of its ads. The headline stated: "This is the story of the investor who lost $31,701 and didn't even know it." The copy went on to show how management fees ate up that much in the potential income from an initial $25,000 investment over a twenty-year period.
When financial services firms sell funds without front-or back-end loads, they may have a very high annual fee called a "12b-1 fee," as noted previously. A fund from a no-load fund family sold by a broker might have a small load attached to it to compensate the broker for making the sale.
Both load and no-load funds are beginning to group buyers according to the amount of their investments. They do this by creating classes of shares for the same fund, generally labeling them by letters of the alphabet. As you might expect, fees on larger deposits are lower. This information is all spelled out in a fund's prospectus.
Here are some rules for understanding fees and share classes on funds sold by brokers. Always review the prospectus so that you will know the exact terms of the shares you're buying.
Consider Class A shares if you're planning to stay in the fund. They have a high initial charge (front-end load), but long term the 12b-1 fees have been low.
Consider B-shares only if you plan to stay for the long term because there is a load, like those for annuities, which generally declines over a six-year period. Early exit triggers a nasty back-end load. Eventually, the high 12b-1 fee declines. There is a longer lock-up period on B-shares than on C-shares.
C-shares, like B-shares, have no up-front load and they have a lower back-end load if you exit the fund before one year. The 12b-1 fee has traditionally been 1 percent.
D-shares are for do-it-yourself investors and may have the lowest fees.
If you are a do-it-yourself investor and looking to keep your costs down, you may purchase no-load funds. Fund families like Vanguard and Fidelity have no-load funds and even lower-cost funds if you have substantial assets to invest. Some funds have instituted retirement shares for 401(k)s and IRAs, which over the long term may have the highest fees of all and are designated by a different letter. Other fund families skip the alphabet soup and have specially designated funds for high-net-worth individuals that have the lowest cost. For example, Vanguard has Admiral Funds, T. Rowe Price has Summit Funds, and Fidelity has Spartan Funds for substantial depositors.
High fees associated with the purchase of funds are there to compensate the broker for the time spent with you. High fees hobble the fund manager in the race to produce good performance results. To compensate for the higher expenses, these funds are more likely to swell the yield by purchasing nonrated, longer-term, and lower-rated bonds.
When you reach for the highest-yielding, best-performing mutual fund, stop for a moment and consider this: a manager took risks to achieve it. Next year the fund could tank even if the strategy remains the same because of changing economic conditions. Strategies that reach for above-average yields are a necessity for funds with substantial fees. To use the stock phrase: past performance does not predict future returns.
We're biased in favor of funds with the lowest costs. We were, therefore, quite pleased to read about work undertaken by Morningstar, the fund tracking and rating company. As reported in November 2001, funds with the lowest fees performed the best overall: "In areas ranging from ultrashort bond funds to the multisector and intermediate-term bond categories, we found that the lowest-cost quartile of funds posted total returns over the year through October 31 that were better than those of the high-expense offerings."[119]
What's more, Morningstar found that the higher-cost funds took on added risk in order to boost the yield and compensate for the added fund costs. The article concludes by pointing out, "If you pay less, you're likely to get better returns and lower risk. That's not a bad combination."[120]
To aid investors, the SEC introduced a free online service in 1999 to help investors calculate mutual fund fees described in an offering statement (the prospectus), accessed via www.sec.gov/edgar/searchedgar/prospectus.htm. The prospectus details the charges levied by your fund and will detail past performance.
The SEC points out that everyone purchasing a fund should read the prospectus, and it recommends the following steps for doing so:
Note the date of issue of the prospectus that appears on the front cover. The date should be within the year of your receipt of the prospectus.
Look at the chart showing the fund's annual total returns and at the total returns compared to industry benchmarks, as well as shareholder fees and shareholder expenses.
To analyze fees and expenses for mutual funds and exchange-traded funds (ETFs), go to the NASD Web site at www.nasd.com/index.htm; choose the "Investor Information" tab at the top of the page and then choose "Tools & Calculators," then "Analyze Mutual Fund and ETF Fees and Expenses," for an evaluation or comparison of three mutual fund companies.
To analyze mutual fund fee breakpoints, go to the NASD Web site and follow the first two steps above; then choose "Look Up Mutual Fund Breakpoint Information." This tool will enable you to check out what discounts and sales charge waivers are available on funds you're considering. This is a complicated tool that comes with a wonderful tutorial to explain how to use it.
Bond traders all look at their bond returns in terms of total return. Because we recommend a buy-and-hold approach for individual investors, we do not look at bonds in this way. Total return takes into account the interest you earn plus the increase and decrease in the value of the bonds. In addition, any transaction costs, fees, and taxes you might have to pay reduces your total return.
Total return for individual bonds is the same concept that's applied to the return on stock or any other investment. The total return concept should not be applied to individual bonds if bonds are to be held to maturity. By marking-to-market the value of your bonds every day, brokerage houses encourage you to evaluate the performance of your bonds based on total return. In this way, they hope that you will be motivated to sell your bonds when you have a gain or a loss without thinking through the advantages of the buy-and-hold strategy. In showing the market movement, they do not trace the tax effects of the transaction or show you the fees and costs of trading.
Bond funds always use the concept of total return because the funds keep the duration of the fund in the same range, selling securities that have a shorter duration and purchasing ones that fit the fund profile. If you place a little bet on market movements, win or lose, the result is not very significant. If you place a big bet, the results can pack quite a wallop. To cite a well-known epigram, "The market may stay irrational longer than you can stay solvent."
In choosing funds, an investor needs to be familiar with the U.S. fund industry's terminology for fund categories. Here, we'll designate four types, with the order ranging from the most closed to the most open. They are unit investment trusts (UITs), closed-end funds, ETFs, and open-end mutual funds. According to the Investment Company Act of 1940, only open-end investment companies may be called mutual funds.
Also known as defined portfolios, UITs are the purest form of a closed-end fund. Once a trust is created and beneficial interests in the trust are sold, it's considered closed with regard to the creation of further shares. Bond portfolios in UITs consist of ten or more securities that are packaged together and sold as a fixed number of shares. The portfolio frequently contains high-coupon bonds balanced by long-term zeros. Once these bonds are selected, the portfolio never changes until the high-coupon bonds are called. When that happens, the income from the UIT, which is why you purchased it in the first place, gradually diminishes until all you're left with are a few interest-paying bonds and a portfolio of zero-coupon bonds producing no income. This happens long before the shares are to be redeemed at the specified date by the originator of the UIT. Faced with the loss of your income, you may sell the UIT back to the originator at a generally unfavorable price. Check Part B of the prospectus to find out about the early redemption provisions on the bonds.
UITs carry high front-end loads or back-end loads (sales charges up to 8.5 percent are permissible, though they are usually between 4 percent and 5.5 percent). The effect of the load is to reduce your return as well as the actual amount of money that you have to invest by the cost of the load. If you consider purchasing them, ask what kind of return it would take to recover your load expenses as well as to make a good profit.
UITs came into vogue in the 1950s, when municipal bond mutual funds were not permitted to pass through tax-free income, but UITs were. It was not until 1976 that the tax laws changed and allowed open-end mutual funds to do the same. Although they no longer serve the alternative, money-saving purpose for which they were conceived, UITs persist as an investment vehicle because their high loads have made them a very lucrative broker product. They're touted as an easy way to obtain diversification without having to pay high management fees. The load fees are always in very small type. We don't recommend UITs.
A closed-end bond fund consists of an asset pool of fixed-income securities. Once the fund is created, the investor trades ownership shares in the fund as stock. When you wish to sell a share, you're subject to the vagaries of the marketplace and how much other investors deem your shares are worth. The value of your shares could be higher or lower than the fund's underlying NAV. In addition, you have to pay a commission to a broker to buy or sell.
Closed-end bond funds, like UITs, have a fixed number of shares, but they differ from UITs in every other respect. Closed-end funds are managed, and the managers have great latitude in their investment practices. Although 80 percent of the bonds in the portfolio must match the description of the fund, the managers may use derivatives to make interest-rate plays, use repurchase agreements, buy zero-coupon bonds, and invest in floating- and variable-rate debt. The managers can and do leverage the bond portfolios by creating and selling auction-rate preferred stock (ARP). The management uses the proceeds from the sale of the preferred stock to buy additional long-term bonds, which may result in higher returns. These activities also give the share price of these funds greater volatility. Closed-end bond funds do not have specified redemption dates and are traded on exchanges like stocks after they're issued. The new-issue investors pay an embedded commission, guaranteeing a decline from the original issue price once they begin to trade.
When the closed-end fund is trading on the exchange, there are two values to watch: the fund's NAV and the market price of the fund's shares. Often prospective investors are not willing to pay the full NAV of the fund, and the shares trade at a discount to the NAV. This happens with such frequency, it seems logical to wait until new issues drop in price before buying. It makes sense to look for those funds that are more deeply discounted than others if the cash flow is the same. A general rule of thumb is that a closed-end bond fund may be an attractive buy when its discount to NAV is significantly greater than its average discount over the previous five years. The thinking is that the share price of the fund is likely to rise as the discount narrows to its normal range. Thumbs come in many different sizes, and so do the discounts that may never disappear even when the NAV is much higher. At such times, investors in these closed-end funds demand that the funds be transformed into open-end funds. Sometimes this happens, and a quick profit is made. More often than not, the investor is stuck with a poorly priced investment.
Closed-end bond funds selling at a discount to their NAV are popular when interest rates are declining. At such times, the yield on the bonds in the portfolio is attractive because it's higher than current market rates. This yield advantage is further enhanced if the price of the fund is at a discount to its NAV. During 2001, when the Federal Reserve reduced interest rates eleven times, investors clamored for the posted yields on closed-end bond funds, so much so that several of the funds were selling at more than 130 percent of their NAV. Other firms, sizing up the profit potential in the situation, scrambled to introduce new closed-end funds. New is better, for the broker, that is, because new funds generate commissions more easily. Nuveen Investments, for example, the most prolific issuer of closed-end muni funds, brought forth twenty new funds in 2001, raising more than $4 billion in the process.
Do closed-end funds yield more than just plain boring individual bonds? With 33 percent leverage, you bet they do. They also have substantially more risk of loss of principal. When the yield curve is flat or inverted, the storm clouds appear on the horizon. Leverage becomes less profitable, and your total return will fall. Although leverage increases your cash flow, it also hastens a decline in fund value when interest rates rise. However, you cannot compare the yield-to-maturity on a bond to the so-called yield on a closed-end fund. Like all mutual funds, closed-end funds pay out any capital gains that might be generated from the sale of an investment. If the bonds in the portfolio are callable and interest rates are falling, so will your dividend returns as the high-coupon bonds are called and replaced with bonds with lower coupons. Furthermore, to maintain the dividend, management may keep liquid assets in case the income is insufficient to generate an even payment stream. Thus, your "income" may be made up of interest, capital gains (on which you pay taxes), and distributions of paid-in capital (your money returned to you). This is a far cry from straight interest paid on a bond, and that's why the two are not comparable. While you enjoy your income stream, you might not realize the differences in income sources until you receive a tax statement at the end of the year.
Management, as well as market condition, counts when it comes to the performance of closed-end bond funds, and the result is a tremendous variation in returns. In 2001, for example, the one-year NAV return among high-yield closed-end bond funds varied from 113.2 percent to 233.1 percent. Even among the more conservative closed-end, national muni funds, the returns varied from a high of 18.1 percent to a low of 20.9 percent. If interest rates increase after you purchase a closed-end fund, you can have the worst of two worlds: declining income and declining market value. For more information on closed-end funds, visit the official Web site of closed-end funds, www.cefa.com.
An ETF containing a bond portfolio is a relatively new concept. It is a closed-end fund that is sold on an exchange. Investors pay brokers for the purchase and sale of the ETF instead of the broker receiving a commission from the issuer. The ETF is pegged to an index, such as the Lehman Brothers Aggregate Bond Index, which means that there is minimal internal trading activity.
The difference between an ETF and a mutual fund is significant. With mutual funds, the cash comes in first and then the bonds are purchased. With ETFs, the creators put the bonds in first and take back "creation units." When you buy stock of an ETF, you're purchasing a piece of a creation unit. Those units remain outstanding until the original creator decides to swap back units for underlying shares in the ETF. The value of the ETF is based on quotes for the underlying stock, because new shares can be created or redeemed almost instantaneously.
There are three advantages commonly attributed to ETFs: (1) you can sell them any time the exchanges are open, as opposed to mutual funds in which you receive the NAV at the end of the trading day; (2) because they are passive portfolios following an index, the management fees are minimal; and (3) the funds are supposed to be tax efficient. Through complicated structures, they may be able to avoid making yearly capital gains distributions.
ETFs also have some disadvantages. They can sell at a discount to their NAV, but the discounts on these funds historically have been less than those on typical closed-end funds. You have to pay a management fee when you own an ETF, as well as a commission to either buy or sell it. There are also trading costs incurred by the ETF because bonds mature and need to be replaced. The ETF management fee does not cover future distribution fees, although they do not assess a 12b-1 fee. These charges add up and could well wipe out any tax advantages in an ETF when compared to those of a no-load index mutual fund. Also, you must determine what the payout schedule might be. ETFs may pay monthly dividends like bond funds, or they may pay quarterly, semiannual, or annual dividends.
Importantly, ETF managers have not invested in their own funds. In a 2006 review of their regulatory findings, Dan Culloton, a senior fund analyst at Morningstar, reported, "Exchange-traded fund families urge you to join the ETF revolution, but many of the people managing their own funds are sitting the uprising out."[121] Visit www.quantumonline.com and www.vanguard.com/ETFs for more information.
An open-end bond fund also consists of an asset pool of fixed-income securities. In this case, the number of ownership shares is not limited. Rather, the fund is inaugurated with an initial number of shares. The total value of the asset pool is divided by the number of shares to come up with the NAV. Because the pool is open, investors can buy additional shares. The buyer is charged the existing NAV, plus any loads, and then the fund manager uses that money to go out and buy more assets. In an open-ended bond fund, you buy a pro rata share of the fund's value. When you wish to exit, or cash out, you're given the NAV of your shares, minus any fees, at the end of the trading day on which you exit. When funds are very popular, they may be closed to new investors.
Open-end funds are just that: the number of outstanding shares changes constantly as investors buy or redeem them from the fund. The fund's bond investments also change as managers readjust the maturities of the bonds, take advantage of favorable market conditions, meet redemptions, or invest new funds.
Unlike closed-end funds, open-end funds are not traded. They are bought either directly from the fund family or from a broker who is an agent for the fund company. Their NAV at the end of the trading day is always the price at which they are bought or redeemed.
A great variety of funds is offered in this format. Information about them is widely published and easily obtained in the media and on the Internet. Prices are quoted daily. Newsletters track funds, giving buy/sell recommendations. Most funds discourage active trading because it requires a portfolio readjustment if cash needs to be raised to pay for the redeemed shares.
Of all types of funds, open-end mutual funds have the most variable fee schedule, depending on whether they're sold by a broker who charges a load or bought directly from the fund company. Figure 14.1 is a table that compares the features of individual bonds to open- and closed-end bond funds.
Cash flow certainty. Individual bonds provide the anticipated income. Open-end funds and closed-end funds will have variable income.
Trading costs. Individual bonds have one transaction cost. Open-end funds are bought and sold at the NAV at the close of the date of sale. All funds pay price spreads (the difference between the buy and sell) to trade bonds, which are passed on to fund holders. Closed-end funds, including ETFs, must be purchased and sold through a broker. Closed-end funds may or may not trade at their NAV.
Diversification. You don't need diversification with individual plain-vanilla bonds because the bonds have high credit ratings, and the default rate is so low. The funds' diversification is so great that it increases the operating and management costs of the funds.
Interest-rate risk. You receive a predictable rate of return on your individual bonds but not with the other vehicles. Even if the fund provides a consistent cash flow, some of that cash flow may be a return of your principal. Funds will lose value if interest rates rise. Their duration usually remains within a specified range. For this reason, we can say that funds, even though they hold bonds, do not provide the same benefits as individual securities.
Principal at risk. Unless there is a bond default, there will be no realized loss of principal if individual bonds are held until they come due. If interest rates rise, you can sell your short-term bonds without much loss and reinvest at the higher rates. Remember, the duration of individual bonds gets shorter year after year. The duration of a fund stays within a range because shorter-maturity bonds are sold and replaced with longer-maturity bonds. Closed-end funds and some open-end bond funds may use leverage, which heightens the risk to your principal while possibly increasing your cash flow. If interest rates have risen from the time of purchase, you will have a greater loss if your fund has leverage. Some funds may also include catastrophe (cat) bonds, which are insurance-linked bonds that translate natural or man-made disasters into credit risks. This high-yield investment pays high returns, making a fund's yield look very attractive. In the event of a disaster linked to the cat bonds in your fund, you may lose part or all of their future interest payments and principal.
Chapter Notes
[118] Paul B. Farrell, "Bond Funds Offer 'Danger Zone' Shield." Retrieved January 29, 2002, from www.cbs.marketwatch.com.
[119] Scott Cooley, "High-Cost Bond Funds Are for the Birds," Morningstar FundInvestor, November 30, 2001.
[120] Ibid.
[121] Dan Culloton, "Do ETF Managers Eat Their Own Cooking?" Morningstar.com, September 12, 2006.