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The Problem With Bond Mutual Funds

February 10, 2011

by Kevin Kroskey, CFP, MBA

(As seen in the Bath Country Journal)

A retiree looking to draw income from a portfolio faces a challenging task today. Thirty years ago interest rates were in the double digits. Today interest rates are close to zero. This stark contrast dictates different solutions to provide income in retirement.

Understanding Total Returns of Bonds

There are two return components that comprise the total return of an individual bond—the price return and the income return. Income return is simply the sum of the interest payments and is never negative. Price return is the change in a bond’s price over time as interest rates change. It is helpful to visualize a teeter totter to see the relationship: as interest rates increase the price of an existing bond decreases and vice versa.

The total return of a bond is equal to the income return plus or minus the price return. A key point is that in a rising interest rate environment the total return of a bond will be less than the income return, if that bond is not held to maturity. If the bond is held to maturity, the total return is equal to the income return and the price return is zero.

In today’s near zero rate environment income returns are quite meager. In addition it is much more likely that interest rates will rise over time than decline. This will negatively impact the price return and thus the total return. Contrast this with thirty years ago when interest rates began falling from high levels, providing both a healthy income return as well as a positive price return, and it’s easy to see the distinct challenge facing today’s retiree.

Individual Bonds or Bond Mutual Funds

Bond mutual funds offer benefits such as diversification and liquidity more so than owning individual bonds. The price return of a bond fund is reflected in the share price of the fund each day the market is open.  If investors start to pull money from bond funds in earnest, outflows will create selling pressure on bonds and thus decrease prices of bonds. This will then cause the price of the bond fund to decline. This type of outflow was seen happening in late 2010 and early 2011 and has made the total returns of many bond funds negative over this time, since the negative price return outweighed the positive income return.

Comparatively, the price of an individual bond may fluctuate over time, but by holding to maturity a floor is placed under the bond return. At maturity, the principal of the bond is repaid and the income return is equal to the total return. Because of the stated maturity of the bond and holding the bond to maturity, the fluctuating price return can be ignored. Bond funds, however, do not have stated maturities and very different results may be realized in a rising interest rate environment when compared to investing in an individual bond.

An example may help illustrate this. From 1950 to 1981 interest rates trended consistently upwards. Over this time, the average interest coupon of a 10-year treasury note was 5.6%. However, the average total return over a five year period was just 2.1%. This loss of more than 60% of the income return is representative of what can be expected from a bond fund in a similar rising rate environment.

Conversely, if an individual 10-year note was purchased in 1962 with a 4% yield, the price of the note would have declined as interest rates rose over the successive 10 years. Yet, if the note is held to maturity, the note would have returned the 4%.

What About Active Bond Fund Managers

Every six months the Standard & Poor’s Indices Versus Active Funds (SPIVA®) is published, showing how effective mutual fund managers are at beating their benchmark. The benchmark is a representative but non-managed comparison index. As of June 30, 2010, SPIVA® showed that across several categories of bond funds, fund managers lost to their benchmark anywhere from 68% to 94% of the time over the preceding five years. By pure random luck, as in a coin flip, you would expect 50% better and 50% worse, but the results for active bond fund management are significantly worse than this.

Implications for Investors

Investors in 2009 and 2010 have plowed billions of dollars into bond mutual funds in search of yield and perceived safety. With interest rates low and likely to trend upwards over time, the risk in bond mutual funds is quite significant and much more than what is perceived by the average investor.

Owning individual bonds can help lessen this risk by providing most likely a win or tie scenario. Win: if interest rates do rise and the bond is held to maturity, the investor will receive the income return of the bond and will not suffer a negative price return. Tie: if interest rates stay about the same, a bond fund and individual bond portfolio should experience similar results. Only if interest rates decline will bond funds perform better than individual bonds.

It should be noted that this article is over simplified for brevity. Next month I’ll expand on this topic.  I will explain how to incorporate this strategy into a financial plan and describe types of bonds and maturities that generally work best.

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm. Kevin will be teaching Retirement Planning Today, an educational course for adults ages 50 to 70, at the University of Akron in March and again in May. For a course brochure and registration information, call 330-777-0688 or email Kevin@TrueWealthDesign.com.

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