Fixed Income

Bond Funds Aren’t the Same as Bonds

First of all, let me state that I am not advocating investing in Bonds or Bond Funds at this time.  My purpose here is to explain why Bond Funds aren’t the same as Bonds.

What is the purpose of investing in a Bond?  Bonds are supposed to provide a modest income stream while preserving your investment.  If you buy a Bond, all you have to do is hang on to that Bond until it matures, and you will get back 100% of your initial investment.  The only risk is that the Bond issuer might go bankrupt.  Even if  the issuer does go bankrupt, Bond holders are in line ahead of investors to get some of their money back.  There have been a few spectacular exceptions, but most “investment quality” Bonds mature and return the principle to the Bond holder.

All the years you hold the Bond, waiting for it to mature, you receive steady, guaranteed interest payments.  Because of the safety of your investment, you are willing to accept interest rates that are a little less than you might be able to receive in other investments.

During the time you are holding the Bond, its “street value” will go up and down.  Unlike stocks, the value of the Bond, after it is issued, doesn’t depend as much on the strength of the entity that issued the Bond, as much as on prevailing interest rates.  If your $1,000 Bond pays you $40 dollars in annual interest, you are getting 4% interest.  If new Bonds being issued are paying 6%, you would only be able to sell your Bond for about $667.  By paying $667 for your Bond, the $40 that the new owner receives annually is 6% of what he paid for the Bond.

Conversely, if prevailing interest rates go down to 3%, a buyer would probably be willing to pay you $1,333 for your Bond.  The new buyer would be getting 3% interest on that Bond.

As a Bond holder, you don’t have to worry about the ups and downs of your Bond’s value.  All you have to do is wait until the Bond matures and you will get $1,000 for it.

Corporate Bonds are usually sold with a face value of $1,000.  In order to diversify your Bond portfolio, you would have to buy Bonds of at least five different issuers requiring an investment of at least $5,000.

In addition, you wouldn’t want all the Bonds to mature at the same time.  Because you don’t know what the interest rates will be when your Bond matures in five, ten, twenty years or so, you would like your Bonds to mature at different times.  That way, when you have to reinvest the $1,000 from a matured Bond, only a portion of your portfolio will be locked into the new interest rate.  For diversity of issuer and maturity date, you might want to invest $10,000 in ten different Bonds.

The average investor would probably need to use a broker who specializes in Bonds to achieve diversity of issuer and relative stability of interest rates.  Bonds aren’t as easily bought and sold as stocks, and the broker’s commission (spread) tends to be greater than with stocks.  This is why Bond Funds were created.  For purposes of this article, I am lumping Bond Mutual Funds and Bond Exchange Traded Funds (ETFs) into the same category.

Bond Funds own lots of Bonds from lots of issuers with different maturity dates.  This diversity reduces the risk of default from small to miniscule.  It can also increase the interest paid by having some higher risk, higher interest Bonds mixed in with lower risk, lower interest Bonds.  Bond Funds are traded like stocks (ETFs) or like mutual funds.  The commissions are low and the prices are published daily.

All this makes it sound like Bond Funds are the best thing since homogenized peanut butter.  You get lower risk and higher interest without having to invest $10,000.  For ETFs and many mutual funds, there is no minimum required investment.  Bond Funds are within the financial reach of almost everyone, and you can buy them as easily as any other investment.

However, with Bond Funds, you give up one important attribute of Bonds – security of capital.

No matter how long you hold shares in most Bond Funds, you are not guaranteed return of your initial investment.  Like Bonds, the daily value of Bond Funds goes up and down, but there is no maturity date.  You have to pick a time to sell your shares in a Bond Fund.  You could sell your shares for more or less than you paid for them.

Bond Funds

The chart above graphs the weekly price over the last five years of two Vanguard Bond Mutual Funds.  The black line is an intermediate-term corporate Bond Fund, and the gold line is a long-term corporate Bond Fund.  You can see that your initial investment could have lost as much as 14% or gained as much as 12% for the long-term Bond Fund.

Because of this, I don’t see much difference between Bond Funds and dividend-paying Stock Funds.  You get a fairly stable income stream and the value of your investment goes up and down.  Until 2013 at least, dividend payments are taxed at a lower interest rate than corporate Bond Funds’ interest payments.  Interest from municipal Bond Funds can be tax-free.

To be fair, this volatility is nothing compared to the volatility of the S&P 500 stock index.  The chart below compares the Vanguard intermediate-term Bond Fund with the S&P 500 index.

Bond Funds vs. S&P500

Today, the yield of the S&P500 (SPY) is 1.69%, while the yield of the Vanguard intermediate-term Bond Fund (VBIIX) is 3.17%.  For the past five years, the Bond Fund value has risen about 9% (vs. about 1% for the S&P 500) and has a better yield.  The main reason for the increase in value of the Bond Fund is that interest rates have been declining for the past couple of years.  The Bond Funds took a major hit around October, 2008 when everything (Bonds, Stocks, Gold) crashed.  But after about three months, the Bond Fund resumed its inverse tracking of interest rates.

The reason I am not recommending investing in Bonds or Bond Funds right now is that I expect interest rates to rise over the next few years.  This means that existing Bonds will be cheaper when interest rates are higher and the yield will be better.

As long as you realize that Bond Funds do not preserve your capital the way individual Bonds do, Bond Funds can be a useful part of your investment portfolio.  Just remember that Bond Funds, like Stock Funds, fluctuate in value, and there is no guaranteed safety of your investment.

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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