The Secret of Bond Funds

Fools Gold

Investors are typically attracted to bonds for two reasons: the preservation of capital and to ‘lock-in? a known, steady stream of income. Bond funds don’t provide either. This will no doubt come as a surprise and disappointment to those who bought into bond funds on the mistaken assumption that these investments have the same characteristics as individual bonds.

Individual bonds provide a predictable income stream from interest payments which are fixed at a specific rate and don’t fluctuate as interest rates change. The income of a bond fund is not fixed. As interest from older bonds is replaced by interest from newer ones, the fund’s income and consequently its monthly dividend will change. Bond fund income streams are not predictable; you don’t know exactly how much you will receive from month to month. Consider that over the last twenty-two years interest rates have generally moved lower and so have monthly dividend checks.

Individual bonds have a fixed maturity date when repayment of the original principal value is received. As a result of this final maturity, the price of a bond ultimately moves closer to par regardless of what is happening to interest rates. Bond funds do not mature. Instead they have a constant maturity or rolling average maturity date, with no end date when principal will be returned. For example, if today the fund holds twenty year bonds, in twenty years they will still be holding a portfolio of bonds. Therefore, market or principal risk is maintained over time and no principal value can be assured at any point in the future.

When you buy an individual bond, you know the yield to maturity (assuming re-investment at the original yield to maturity rate) as well as the annual current yield (income divided by price) for the life of the investment. Because the portfolio of a bond fund does not mature on any single date, the yield quoted by a bond fund cannot be compared to the yield to maturity quoted for individual bonds which assumes, among other factors, that the bond will be redeemed at par. The yield quoted for a bond fund, called its 30 day SEC yield, is a snapshot of the distributions, an expression of income divided by NAV (Net Asset Value) which does not take into consideration the principal value at some point in the future. Bond fund managers tend to buy premium bonds to pump up income with the side effect of deteriorating NAV.

Time Magazine felt so strongly about the disadvantages of bond funds that they published an article, ‘Bond Fund Buyer Beware? (March 2, 1998), which contained the following comment:

‘These differences are so fundamental that it’s a stretch even to call them bond funds. They’re more like a stock. In fact, if you have money in a bond fund, what you really own is common stock in a company that invests in bonds. Clearly, investors seeking to preserve capital and earn a fixed income stream for a set period of time have no business flirting with bond funds. They should go for individual bonds. Yet bond funds are routinely marketed as apt substitutes.?

Bond funds simply do not offer the key benefits that are characteristic of bonds. Now is the time for you to review those bond investments with a financial professional.

Loran S. Coffman is a Representative with H. Beck, Inc. and may be reached on the web at www.WPSinvestments.com, by phone (248) 693-5599, or by email Advior@WPSinvestments.com.

These views are those of the author and should not be construed as investment advice. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.

Securities offered through H. Beck, Inc. Member FINRA, SIPC. Investment advisory services offered through M.R.Spencer Advisory Services, LLC. WPS-Investments, Inc. is unaffiliated with H. Beck, Inc. Lighthouse 436 S. Broadway, Suite F, Lake Orion, MI 48362