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How do Bond Funds Work?

This post was inspired by a relative that asked me for a good investment option for the bond portion or bond like portion of his portfolio. I want to highlight a few important things about these investment options over a series of posts.

Types of Bond Funds

The first bond like investment I want to highlight are bond funds. The advantage of a bond fund is diversification of bonds held, limiting your risk. There are a number of different types of bond funds:

  • Stable Value Funds – Generally these are funds that deliver a return while protecting principle using contracts from insurance companies and banks. They do this in a number of ways. It is important to understand they still have risk but they are backed by multiple institutions.
  • Inflation Protected Index Funds- Investing in inflation backed securities from the government.
  • Tax Advantaged Index Funds – Investing in municipal bond or other areas of the market that are tax exempt in certain cases.
  •  Total Bond Funds – Investing in the total bond market, across all low credit risk categories.
  • Index Bond Funds – Targeted at specific debt quality.
  • Active Bond Funds – Investing at the whim of the person who runs the fund.
  • Junk Bond Funds – Investing in low quality investments that provide a higher return.
  • Corporate Bond funds – Investing in bonds of corporations
  • Mortgage Backed bond funds – Investing in Packaged Mortgages.
  • International Bonds – Investing in International bonds.

Credit Risk

Some things to remember about bond funds. The first is to always check the credit risk distribution to understand your risk exposure from the bond. The rating percentages will tell you the inherent risk of the underlying securities to experiencing a default, IE going to 0 or significantly losing principle due to the underlying issuers insolvency. Government are considered the safest and risk increases as you work down to CC or DD depending on rating agency. In general you don’t want to go below BAA. High risk bonds, or Junk bonds, fall on the lower end of this scale and tend to correlate with the stock market. Stock market correlation is exactly what you do not want to have in this portion of your portfolio. At that point you would be better off holding stocks, as this type of bond will move up and down with stocks.

Total Bond Mkt Index as of 10/31/2016
U.S. Government 62.9%
Aaa 5.9%
Aa 4.6%
A 11.7%
Baa 14.9%
< Baa 0.0%
Total 100.0%
Average effective maturity 8.1 years
Average duration 5.8 years

Inflation Risk

The second thing to understand about bonds is they have a secondary risk due to interest rate changes. If a change occurs they can actually lose value. Typically a bond fund will tell you how exposed it is to interest rate changes with a measurement called average duration. This tells you the amount the price will decline for each increase in interest rates. For example if interest rates increase from 2-3 percent you will see a decline in total bond of 5.8% because of the 1% move. This also gives an example of why bonds decrease less at the extremes than dips in the market over the long run. Couple that with the low failure rate with high quality bonds, and the result is less variation. For example it would take a 9% move in interest rates in a single year to have a bond fund like Total Bond experience an equivalent loss to what happened to stocks in 2008.

Expenses

If you do invest in a bond fund remember to observe the expenses and shoot for the class of funds with the lowest expense rate. This is especially important when making a fixed low interest rate return.  The impact of a expense ratio, as measured as a percent can erase most of your return. Please also note it is not uncommon in this class of investment to have up front or back end expenses that you incur when you purchase and sell bond funds. Watch out for these, I generally avoid this type.  Many funds also have share classes based on the amount you invest, with certain classes paying lower expenses. As such you may want to concentrate your investments in only a few funds for the best deal.

Within the fund types previous mentioned there are a large amount of variation, below are some specific things to consider.

Total Bond

Lets first talk about Total Bond Funds. Total Bond has come in for some criticism as of late because a good portion of Total Bond is held in US government bonds, nearly 63% per Vanguards website. This tilts your bond portfolio performance heavily towards safe government bonds and less towards corporate bonds. You want some of this given we are talking about the low risk portion of your portfolio but too much government will lower your overall return. These funds are generally returning about 1.81% over the last year so you can see the downside. It’s worth considering Total Bond in conjunction with some other funds or bond like holdings focusing on a different risk rating. Consider mixing and matching to achieve a lower percentage of government securities closer to 30-40% with a slant more towards AAA rated bonds.

Active Funds

Active bond funds allow for a slant towards whatever proportion the person leading the fund decides. You could have funds focusing on high quality, low quality, different categories, or anything in between. The issue is you are assuming both the ability of the bond fund manager and the consistency of that manager. Unfortunately, there have been a large number of issues in this area with Hot Shot bond fund managers leaving their companies for competitors and those who were once hot going on a losing streak. I do not recommend active bonds for this reason though I’m also not entirely a fan of Total Bond by itself.

Inflation Protected Bonds

I also do not personally recommend TIPS funds. Historically, it has lagged the other options in terms of return. While bond fund return is inevitably low given current yield, these specifically are just too low for me. TIPS may offset some of this lowness by adjusting for inflation. Given inflation has been low as of late, returns have also been low. However, realize they adjust their rates to inflation once every 6 months based on the government inflation measurement Consumer Price Index. Unless interest rates are stable you will lose money while they catch up to any rate change. Also some have questioned whether the contents of the Consumer Price Index accurately reflect inflation. Given this, I just don’t see the benefits outweighing the risks.

International Bonds

One other area I avoid are international bonds and I would strongly recommend you do as well. Simply put, the variation of bonds and the return itself are much lower than stocks. The risk that the currency the foreign bonds underlying the fund are invested in will shift relative to the fund’s home currency is the same as it is for other international investments. This means the currency risk usually outweighs any potential increase in return for a foreign market bond. For me, the currency risk significantly outweighs the benefit. Say you invest 10K in a European bond fund. It returns 5% compared to the US fund. However the Dollar appreciate versus the Europe from 1.25 dollars per euro to 1.19 dollars per Euro. Well, essentially your return is now 0 as the currency change has wiped out your savings.

Stable Value Funds

Stable value funds meanwhile are funds where the underlying diverse set of securities return is guaranteed by insurance companies or banks. Honestly, I can’t recommend these due to their opaqueness. You do not know what assets are in these funds, nor is it obvious whom is backstopping them. If you look back to the 2007 crash, many of the mortgage backed securities were insured by various insurance companies. Unfortunately, both the mortgage backed security and several of the insurers went under, which resulted in this then thought safe investment collapsing. It’s possible you could run into the same issue with a stable value fund. I’ve personally found the ones I have access to do not give me the information I would need to evaluate risk. If you find one that does, it may be worth a look if you can tolerate a low guaranteed return.

Tax Advantaged Bonds

The final type of bond I would like to highlight are the tax advantage options. These invest in bonds that would be tax exempt, and are usually government in origin. The important thing to understand is usually the most efficient of these for your purpose will be ones that focus on your own state. Municipal bonds issued from your own state are typically not taxable by your state, but an investment in another state’s bond will likely still be taxed by your state. The reality is tax advantage bonds and non tax advantage bonds maintain a relationship in an efficient market where 2 bonds with the same risk differ in return only by the amount of the average tax advantage of the holders. Assume the average holder has a 25% Federal tax bracket and 5% for State tax, so if your return does not exceed the taxable bond minus 30% then you are better off with a taxable bond.  To do this you must get both the federal and state tax breaks on these bonds by buying those for your state only.

Non Taxable bond= Taxable bond of same risk – average tax deduction
If tax deduction < Avg tax deduction then Taxable bond>Non Taxable Bond

I hope you learned something about bond funds by this post.
Do you invest in bond funds, if so which one?

 

5 Comments

  1. Mustard Seed Money
    Mustard Seed Money November 25, 2016

    Such a smart and concise article. I took a bond class in College and I have to say that you did a much better job of explaining everything. Thanks for the refresher!!!

  2. Andrew Li
    Andrew Li November 26, 2016

    Wow great summary! I haven’t invested in bonds in a while because rates have been pathetically low. However, I might consider if rates keep on the current trajectory. Thanks for the great recap.

    • fulltimefinance@fulltimefinance.com
      [email protected] November 27, 2016

      Thanks, I think if topics in the financial press are any indication you won’t be alone.

  3. FinanciaLibre
    FinanciaLibre November 27, 2016

    Nice overview, FTF!

    Some interesting events in the bonds markets the last couple of weeks. I think it’ll be an adventurous year for bond investors in 2017!

    Cheers!

    • fulltimefinance@fulltimefinance.com
      [email protected] November 27, 2016

      It’s amazing how quickly the rates jumped. If that is any indication of things to come I think your right.

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