IN THIS CHAPTER, we'll look at bond funds from the point of view of their taxable status and, within that status, consider the different portfolio types. When comparing the returns on bond funds, it's very important to examine their portfolios to understand why the returns are different. As you'll see, types of bond portfolios may be presented in more than one format, which we'll point out as we describe each one. The fund types are presented in alphabetical order.
There are fewer varieties of tax-exempt funds than there are taxable funds. We describe four here. Just as you would for individual municipal bonds, compare the after-tax return on a taxable bond fund with a tax-exempt fund to determine which would give you a better return. Between October 2005 and October 2006, municipal bond funds returned 4.22 percent compared to taxable bond funds, which returned 4.16 percent, according to Morning-star.[122] Furthermore, Peter J. DeGroot, vice president and head of municipal strategies at Lehman Brothers, reported that in August 2006 the tax-adjusted returns on municipal bonds for those in the highest tax bracket were 9.63 percent during the previous ten years, compared to 6.88 percent for taxable bonds.[123] Past performance is no predictor of future returns, but if we can reduce expenses, we have a better chance of coming out ahead.
Check out the yields on the state-specific funds compared to the national funds to see if you can avoid paying state taxes as well, while helping to support the state economy by being a lender. Although you may think you should buy a fund with the name of your state on it, there are times when a national muni fund would be more advantageous. Funds may purchase bonds subject to the AMT in order to boost yields. If you're subject to this tax, you might want to check into the fund's policy and review its portfolio before you buy. You might earn more, on an after-tax basis, in a fund that holds no AMT bonds than you would in a fund that holds only bonds of your state of residence.
As described in chapter 10, the credit quality of municipal bonds varies tremendously. Bonds at the lower end of the spectrum are forced to offer a higher yield to attract investors. Some financial institutions buy these up and package them as high-yield municipal bond funds. These funds suffered great setbacks in 1999 and 2000 as a result of the credit crunch following the bankruptcy of Orange County, California. Investors in a Heartland Advisers fund, for example, saw the fund's value decline by more than 70 percent in one day.[124] These losses were the result of illiquidity in the high-yield market, which limited the ability of the pricing services to adequately value the bonds. The fund manager decided to retain higher values than were justified. Heartland management repriced the funds when they learned about the problem.
Although Heartland got caught in the crunch, other high-yield funds suffered as well. When the savings and loans stopped lending because of their own credit crisis, municipalities opened the spigots to let industrial-development bonds flow. Generally backed by the revenue generated from the projects, many failed to reach their revenue targets. Although municipal bonds are generally considered a credit snooze, industrial-development bonds were racking up defaults.
In short, high-yield municipal bond funds are every bit as risky as corporate high-yield bond funds. Buyers of these funds must be ever vigilant. The funds are available as open-end mutual funds and as closed-end funds.
These funds offer all the convenience of traditional taxable money market funds plus their income is tax exempt. The trade-off is a smaller pretax yield than that offered by traditional taxable funds. These funds are divided into national and state-specific funds. National funds generally provide higher yields than state-specific funds as well as greater diversity. However, someone in a high-tax state, such as California, might choose a state-specific money market mutual fund to receive income that is exempt from local, state, and federal taxes. You won't find this type of fund at banks, which currently offer taxable FDIC-insured money market accounts.
Containing short-term notes with a maximum maturity of thirteen months with an average maturity of ninety days, the bonds in the fund are named for the source of the funding that will repay them. Thus, a Treasury money market will hold Treasury bonds, and a cash-management account will hold a variety of instruments that are more risky. A muni money market fund will hold munis and may contain bonds subject to the AMT unless otherwise specified. State-specific muni money market funds appeal to those in a high tax bracket in a high-tax state. These funds also buy tax-free commercial paper issued by municipalities and variable-rate debt to satisfy the demand for product, as well as auction-rate securities or variable-rate demand obligations, long bonds sold with short puts of seven days or a month or more.
There have been no losses in money market funds so far even when a security defaulted. We don't worry about money markets from big mutual fund companies. Historically, if a security defaulted, the mutual fund companies purchased the defaulted security from the money market fund at its face value to maintain its dollar-per-share price. Sellers of money market funds chose to reduce their fees to avoid "breaking the buck," which occurs when the management fees and expenses exceed the income of the fund.
Unfortunately, those who invested in money market subaccounts through their variable annuity found that they got a negative return when the fees exceeded earnings, while surrender charges prevented them from switching to another fund. In the annuity world, a negative return "is just not as visible," according to Brian Nestor, head of Vanguard Group's annuity and insurance services unit, "because you don't have a buck going down to 99 cents or 98 cents, [and without that high visibility] I don't think our providers feel the need to waive fees."[125]
These funds come in two varieties: investment grade and high yield (junk). The title of the fund will tell you which variety it is. Included in these funds are bonds from all states.
Investment-grade funds, like their corporate cousins, come in short-, intermediate-, and long-term varieties. Some bond funds contain only insured bonds, which pay a lower yield in exchange for the added protection. Because of the broad diversity of these funds, many believe that the extra protection is not necessary.
If your state charges income tax on out-of-state bonds, the fund management will provide you with an end-of-the-year statement that will outline what percentage of bonds it holds from all states as well as the taxable income that results from bonds subject to the AMT. If 10 percent of the bonds were from your state, for example, you would not pay any state income tax on that income. Both investment-grade funds and high-yield funds are available as UITs, closed-end funds, and open-end mutual funds.
If you have to pay high state taxes on bonds issued by other states, you should invest in state-specific funds. These funds provide income that is free of all income taxes. The funds may be more volatile than national market funds if state-specific credit quality issues arise. Always compare the returns on state-specific funds with the national counterpart. Buy the national funds whenever your tax situation permits. These state funds always contain the name of the state in the title. They are available in UIT, closed-end, and open-end mutual fund formats and may contain bonds whose income is subject to the AMT.
From 2000 to 2002, billions of dollars were pumped into taxable bond funds as investors fled the falling stock market. These investors were seeking an easy way to capture the safety and promised return of bonds. Although investors have drifted to gold, real estate, and the stock market, in 2007 money continues to pour into bonds both nationally and from overseas investors who are "hungry for yield."
The moral of bond fund performance is that the funds run the gamut of the risk spectrum, although the spreads on high-yield versus investment-grade bonds are still quite narrow. The fund categories that follow are arranged in alphabetical order. We considered putting the safest and most conservative first, and the riskiest, most volatile, and potentially most lucrative last, but that would have been misleading. Some kinds of bonds in funds are intrinsically safer than others, but there is always the 20 percent of a fund's assets that managers may invest at their discretion. That may make a bond fund less safe than it appears.
If you're searching for added return, sellers of these covered-call funds hope you will choose them. The funds get their name from the fact that they buy stocks and then write call options on them. The options generate cash but limit the upside potential of the investment. If the price of a stock in the fund rises above the call price, the stock is called away. However, there is no limit to the downside movement of the stock. Mushrooming with the low interest rate in 2006, this fund category was created twenty years ago, but fell into disfavor as performance lagged. To support this fund, a BuyWrite Benchmark Index was created by the Chicago Board Options Exchange. The index tracks the movement of the S&P 500 and the call options sold against it. These funds have an expense ratio greater than 1 percent. They are closed-end funds, sold as bond alternatives.
Convertible bond funds behave more like stocks than bonds and are a steamy addition to any portfolio. Read all about the underlying components of convertible bonds in chapter 11 and note in particular that the majority of convertible bonds are below investment grade. These funds perform best when the stock market is on a roll and interest rates are rising. If you're looking for safe income, it's best to look elsewhere.
Compared to losing stock market returns, convertible bond funds posted gains between 1999 and 2001. Since then they have been weak performers. If you're looking for gains to top stocks, check out convertibles when stock market volatility is subdued. Investing in the lowest-grade bonds is not always a walk in the park. In February 2002, for example, Lipper and Company's convertible hedge fund slashed its value by 40 percent. This dramatic one-time repricing reflects a fund manager's desperate attempt to cover losses in the hope that better times are imminent. Hedge funds are attracted to the potential outsized returns of convertible bonds. Between 2002 and 2006, these funds have been weak performers. They are available as open-end funds.
Funds in this category will vary greatly in their holdings and in their returns as well. They can contain almost any kind of investments in widely different proportions, as long as the prospectus discloses the information. The yearly turnover of a portfolio can be as low as 20 percent or as high as 80 percent. The fund can be dedicated to providing high income or total return but not to both simultaneously. Probably more so than for any other fund category, it's important to know the investment philosophy of the sponsoring firm. The Vanguard High-Yield Corporate Fund, for example, consists principally of cash-paying bonds that carry credit ratings of B or better, which means that some of the bonds in the portfolio are investment grade. This mix lowers the fund's yield, but reduces exposure to bond defaults and losses of capital.
Other high-yield funds contain predominately C-rated bonds, which could send shivers of despair through some investors and trigger dreams of lucrative glory in others. Try to uncover why the fund you're considering offers a higher yield. To estimate the risk of a higher-yield bond fund, before investing you should find out the breakdown of its credit quality, sector allocation, and average maturity and compare them to those of similar funds.
The perceived wisdom on the Street is that the best time to buy these funds is after there has been a shakeout in the corporate market, with lots of defaults. The thinking behind this is that when the recession is over, it's likely that the survivors will be able to regroup and sustain themselves until the next downturn and credit squeeze.
Because this book is intended for use in both good times and bad, we must remind you that during the period before a recession is actually announced, these funds can get dicey. Between 1999 and 2000, for example, there were $11 billion of redemptions in junk bond funds, leaving the valuation of the underlying bond portfolios in question. One analyst reckoned that some managers were overstating the value of their bonds by 10 percentage points or more. That was partly because the market became so thin that they were hard to price, but also, presumably, because their true values were so frightening.[126] You can compare your fund performance to an NASD-Bloomberg Active U.S. Corporate High Yield Index at www.investinginbonds.com. There are both closed-and open-end varieties of corporate high-yield bond funds, as well as exchange-traded funds.
Containing bonds in the top four rating categories, investment-grade corporate bond funds are grouped into those with short-, medium-, and long-term maturities. It is important to consider these maturity distinctions because long-term corporates are extremely sensitive to changes in interest yields.
From 2000 to 2006, investment-grade corporate bonds have been very popular with overseas investors. For example, in 2001, these investors purchased almost half of all new corporate bonds. In 2007, the media is still waiting for the moment when these bonds fall out of favor with foreign investors, anticipating that there could be a value decline in funds holding these bonds. Before buying such a fund, ask if junk bonds are included in the mix to spruce up the yield. These funds are good to park in your retirement accounts because you can defer paying taxes on their income. Investment-grade corporate bonds are available as either closed-end funds, open-end funds, or ETFs. Check out your fund against the NASD-Bloomberg Active U.S. Corporate Investment Grade Index at www.investinginbonds.com.
If you choose to purchase stock through a mutual fund emphasizing dividends, keep in mind that in 2006, "the average equity-income offering in Morningstar's mutual fund database has a net expense ratio of 1.40 percent. The average 12-month dividend yield—which is paid after management and administrative fees—is only 1.63 percent,"[127] reported Josh Peters, the author of the Morningstar DividendInvestor. The managers of these funds need to show that their stock picks outperformed those in other funds so the turnover rate is 51 percent annually, according to Peters, which further generates transaction costs and taxes on capital gain. If you purchased the S&P 500 in 2006, the average dividend yield was below 2 percent.[128] These yields are very low compared to bond yields, but then you're always hoping for stocks to appreciate. This category is considered a bond alternative. It is sold in closed-end fund, ETF, and open-end mutual fund format. Sometimes municipal bonds are mixed in.
International bond funds invest only in foreign bonds. Global bond funds may hold U.S. corporate bonds in addition to the bonds of foreign issuers. There are also funds that hold bonds of emerging markets or sectors of those markets. Multisector and balanced funds may contain a mix of foreign and U.S. securities. These funds have higher fees and greater risk than U.S. bond funds. Currency fluctuations present a unique risk to this bond sector no matter what the maturity structure. Ask yourself if you're prepared to bet against the U.S. dollar. Some people do, but timing is everything. The funds are available in closed-end, open-end, and ETF formats.
This is a catchall category, but it is not a one-size-fits-all category, despite its benign title. These funds can contain a variety of securities. Some are plain-vanilla funds having a mixture of Treasuries and agency securities and mortgages. Some of the mortgage debt might not be issued through government agencies. Others may allow the trading of futures and options, which increases potential profit and multiplies the risk. Some funds are managed for total return and include the separate trading of STRIPS. Look in the prospectus to find out what securities are in the fund portfolio and review chapters 6 through 9 to understand what you're purchasing. They are available in closed-end and open-end formats.
The GNMA funds are popular. The funds invest in mortgage-backed securities guaranteed by Ginnie Mae, an agency of the U.S. government (see chapter 9). These funds are very liquid and of high quality. Here is an example where bigger is better, and Vanguard takes the prize, though Fidelity, USAA, and Payden-funds GNMA funds are good performers, too. The largest funds have usually enough diversity to cushion market fluctuations from principal prepayments while providing very attractive risk-adjusted returns. When the rate of mortgage refinancings increases rapidly because of declining interest rates, this fund does not perform as well as funds with noncallable bonds. However, this kind of fund handles moderate ups and downs well, especially if the fund is very large. Size matters here because mortgage securities are always being called and new ones purchased to replace them. We recommend that your GNMA purchases be through a fund because of the unpredictability of the calls and pricing opaqueness. They are available through open-end mutual funds.
Like stock index funds, bond funds that are indexed invest in a broad array of bonds that represent a sampling of the bond index rather than all the issues in the index. Currently, the index of choice is the Lehman Brothers Aggregate Index for investment-grade bonds, though some index funds use different standards of measurement. Thus, while the Lehman Brothers Aggregate contains more than 5,000 issues, a fund may hold only a fraction of them. Fund managers have considerable flexibility in what they choose to buy, and bonds may be traded more than you would expect.
Bonds incorporated in the index must come from sizable issues. Government and corporate bonds make up 70 percent of the index, but mortgage-backed and asset-backed securities and Yankee bonds are also included. When a bond's maturity falls below one year, it is dropped from the index and from these portfolios. Although the bonds in the funds do not precisely mirror the index, management attempts to match the duration and yield profile of the index so that the fund returns will be comparable. Led by Vanguard, other index fund providers have lowered their fees to remain competitive.
Index funds come in short, intermediate, long, and total market formats. As a policy, they tend to steer away from low-grade bonds. Those who believe in indexing make a powerful case for bond index funds. Standard & Poor's in 2006 reported in its S&P Indices Versus Active Funds (SPIVA) quarterly: "[Bond] Indices outperformed in six of eleven styles [of funds] over the past three years. Indices outperformed in ten of eleven styles over the past five years."[129] In the second quarter, 2006, "only long-term government and short-term general [bond] funds outperformed their indices."[130] Furthermore, John Bogle, founder of the Vanguard Group of mutual funds, states that in "the mutual fund field, risk and reward go hand in hand only if cost is held constant."[131] In 2006, Fidelity Investments lowered the costs of its index funds below those of Vanguard to become the industry leader.[132]
Until recently, bond index funds were offered only in the open-end format. The introduction of exchange-traded bond funds has changed that. The ETFs also mirror indexes and are purported to have the additional advantage of not passing through capital gains although as of 2006 there had not been a significant difference. Information about index funds is posted on the Internet at www.indexfunds.com. Bond index funds are available in open-end and ETF formats.
These funds are relative newcomers to the mutual fund family, with asset pools primarily consisting of TIPS issued by the Treasury (see chapter 6). Although these funds are thought of as conservative investments for individuals fearful of inflation, at times they have delivered very handsome returns. However, they do not fare as well in a low inflation scenario.
TIPS are a type of bond that is advantageous to own through a fund. When owned individually, some of the return is added to the principal amount but is not realized until the bond matures. Nevertheless, if you own the bond outside of a tax-sheltered retirement account, you will have to pay tax on the phantom income you receive annually. However, when TIPS are purchased through a fund, you receive not only the current income but the increase from the inflation accrual as well.[133] Bond managers pass on this benefit to you by selling the fraction of the face value of their bond holdings corresponding to the inflation accrual. Inflation-protected bonds are available in open-end and ETF formats.
This type of fund consists primarily of repackaged bank loans and contains risky credits made to finance many financial activities, including highly leveraged buyouts, mergers, and acquisitions. When the economy is troubled, the liquidity of these securities evaporates.
The purpose of the fund is to provide income. Preservation of capital is secondary. If the notion of higher-than-average income flow excites you, consider what would happen if there were defaults and the principal was no longer there to generate that income. The loans are usually B-rated paper—that's junk bond quality. Low interest rates have nurtured troubled companies, making these funds appear safe, but an upturn in rates will trigger defaults. A flagging economy increases the risk that you will lose money invested in a loan-participation fund. Expect a 30 percent loss if the fund is not leveraged. If it is leveraged, you will lose more. If you are getting a rate of return of 8 percent or better, the fund is leveraged.[134]
Similar funds are sold with names such as "floating rate" or "prime rate" in their titles, although they are hardly prime. Because the loans held by the fund are short term, these funds are often sold as higher-yielding alternatives to money market funds. Banks are now delighted to have a way to shift the risk of widespread loan defaults to investors. Substantial fees further cut down the attraction of these funds so they often are leveraged to goose up the yield. Loan-participation funds frequently return cash when the loans are prepaid, triggering some capital gains that are passed on to the shareholder. They have the same pricing difficulties as high-yield bonds. Expect the market liquidity of these funds to dry up once defaults are reported. The nail-biting quality of these investments increases when you see both your principal and income disappear as companies fail to meet their debt obligations. To maintain liquidity, the funds must keep a substantial sum in cash and liquid securities. Originally appearing in the closed-end format in 1988, they are still sold that way.
Stable-value funds and individual guaranteed investment contracts made up 21.3 percent of the assets in 401(k) plans in 2006.[135] These funds often have the word preservation in their title because of the SEC's restriction on the use of the term stable. They're composed primarily of new age guaranteed investment contracts (GICs), asset-backed securities, and corporate bonds. Banks or insurance companies provide a "wrapper," or insurance policy, that cloaks the assets and insulates them from market swings. Like any other investment, the quality of these funds will vary depending on the asset mix. To compete in the market when interest rates are rising, some of these funds are apt to adopt riskier strategies like investing in non-U.S.-dollar bonds hedged against currency risk and using nondollar, fixed-income futures.
These wrappers may not prevent a default because you're relying on an insurance company to protect you. Trust Advisers Stable Value Plus Fund declared bankruptcy in 2005 as a result of imprudent investments. As a result of a settlement with Circle Trust, the adviser to the fund, the 1,500 pension plans invested in the now $200 million fund will receive all principal plus a little interest. This was not a mutual fund but rather a collective trust. These entities do not have to provide daily pricing and detailed prospectuses to the SEC because the SEC does not regulate the trust.[136] GICs also ran into trouble in the 1990s when Executive Life and Mutual Benefit Life failed.
Stable-value funds were investigated by the SEC in 2004 because their underlying investments fluctuated in value yet the NAVs always remained stable.[137] As a result of the SEC's activities, many funds closed. Those remaining have had to adjust their portfolio content and oversight to meet the SEC's objections.
Penalties established either by the fund or by the retirement account regulations may be imposed for early withdrawal or for withdrawal whenever the ninety-day commercial paper rises to a level above a fund's payout. To find these funds, visit www.stablevalue.org. They are sold as a bond alternative.
Players seeking high total returns in the high-yield, foreign, and U.S. bond markets gravitate to this type of fund. Relatively new to the game, the portfolio managers can shift their assets to the sectors they view as most rewarding. It's very difficult to evaluate these funds because there is no benchmark against which to measure them. They're considered to be very high risk. They are available as closed-end and open-end funds.
These funds hold bonds that pay no current interest. Unless held in a tax-sheltered retirement account, you must report the imputed interest every year, that is, the interest they would have paid if they were paying interest. The title of the fund states a targeted maturity, but what is referred to is really a targeted duration. The entire bond portfolio does not come due at the same time; however, bonds that do not mature with the majority of the securities are sold at the fund maturity target. Composed mostly of Treasury and agency bond strips (see chapters 6 and 8), the funds pose no default risk. Although they may be purchased to buy and hold, more often they are bought to make an interest-rate play. In a declining interest-rate market, these bonds appreciate rapidly. Longer-term funds are extremely volatile. For example, a 1 percent decline in interest rates on a portfolio of zero-coupon bonds with a ten-year duration will result in a 10 percent gain, whereas a corresponding 1 percent increase in interest rates will provide a corresponding 10 percent decline in fund value. In addition to price swings, especially on long-maturity funds, these funds may have restrictions on selling large positions in order to limit trading. Read the portfolio carefully before buying. Adding these funds to a prospectus is not for the timid. Find them among closed-end and open-end funds.
Like their zero-coupon relative, these funds target the date of your retirement. Unlike the straight target bond fund, the fund is a "fund of funds." It's a wrapper containing bond, stock, real estate, or other types of funds. The fund presumably starts out with a high percentage of stocks, which gradually are replaced with bonds over the years. You pay two levels of fees: one for the underlying fund and another for the wrapper. This type of fund surged in 2003, becoming the most popular new type of fund for retirement accounts when it became apparent that most individuals ignore retirement planning and do not rebalance their portfolios. Mostly managed by Fidelity Investments, Vanguard Group, and T. Rowe Price Group in 2006, they are not all structured the same. Although each manager has a similar variety of investments, they are held in different proportions. They increase their bond holdings on a variety of schedules as retirement approaches. Unfortunately, holding your assets in bond funds will not protect your principal the way individual bonds do if interest rates rise. It's important to read the prospectuses if you choose this type of investment, and to reevaluate your decision periodically. They are found among open-end funds.
Plain-vanilla Treasury bonds fill these funds in short-, medium-, and long-term maturities. Paying the lowest yields, their claim to fame is safety and state tax exemption. We cannot understand why anyone would buy these funds when they could buy the Treasuries in minimum amounts of $1,000, for no transaction or management fees through TreasuryDirect or through your broker for a one-time fee (see chapter 6 for details). Treasury bond funds are available in closed-end, open-end, and exchange-traded funds.
These funds invest in floating-rate securities, whose interest rates are periodically reset. The definition of ultrashort varies from one-year to five-year maturities. Likewise, the mix of securities and the use of derivatives differ from one portfolio to another. The fund's purpose may be high current income only, or it may also aim for capital preservation and liquidity. The fund may be called adjustable rate, variable rate, short term, capital preservation, or have ultrashort in the name.
Ultrashort bond funds have high expense ratios. They do best in a down market and may not earn enough to cover their expenses when interest rates are falling and bond prices are rising, as was the case for the Strong Advantage (STADX) in 2001, even though it had a duration of 0.75 years. It was not the worst performer in this category. Since they are not money market funds, there is no commitment to maintain an even share price of $1 per share as does a money market although some funds in this category do so. An alternative to this kind of fund might be a short corporate bond fund or short corporate bonds themselves. Open-end mutual funds are the place to look for them.
Chapter Notes
[122] Virginia Munger Kahn, "Mutual Funds Report; Good Times Keep Rolling for Municipal Bonds," New York Times online, October 8, 2006.
[123] Ibid.
[124] Joe Mysak, "Events at Heartland Are Only the Beginning," Bloomberg.com, October 25, 2000.
[125] Karen Damato, "Money Funds Offered by Annuity Firms Break Below $1 Net Asset Value Level," Wall Street Journal, November 8, 2002, C1, C13.
[126] "Corporate Bonds: Debt Delirium," Economist, May 20, 2001, 90.
[127] Josh Peters, "The Case for Income from Individual Stocks," Morningstar online, September 8, 2006.
[128] www.indexarb.com, September 12, 2006.
[129] Standard & Poor's, Indices Versus Active Funds Scorecard, Second Quarter 2006, July 19, 2006, 3.
[130] Standard & Poor's, 1.
[131] John Bogle, Bogle on Mutual Funds (New York: Richard D. Irwin, 1994).
[132] Jim Lowell, "In Pictures: Five Hidden Gems among Fidelity Index Funds," Forbes online, September 13, 2006.
[133] Frances Denmark, "Safe Harbor," Bloomberg Wealth Manager, December 2000/January 2001, 88.
[134] Don Martin, "High-Yield Bank Loan Mutual Funds May Offer Hidden Risk," Los Altos online, September 20, 2006.
[135] Jan M. Rosen, "Just How Stable Is 'Stable Value?'" New York Times, October 8, 2006, BU 28.
[136] Ibid.
[137] Eric Jacobson, "Is This the Death of Stable-Value Funds?" Morningstar online, August 18, 2004.