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Financial Opinion and Insights

Looking at Bond Fund Yields?

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

There’s more to look at.

Yield can be a poor evaluator when comparing bond mutual funds, simply because there is no maturity date. 

You see, individual bonds have a maturity date.  Regardless of interim price swings, bonds are designed to mature at face value.  So, if you own a 5-year bond with a face value of $10,000, it will mature at $10,000 regardless of the interim price swings.

Not so with bond funds.  They have no maturity date.  When you own a bond fund, your money is pooled with other investors in an actively traded portfolio.  As a result, bond mutual funds can appear to have nice yields, but can still lose a significant portion of value from even a slight interest rate increase in the bond marketplace.   The reason is simple, when interest rates increase, existing lower rate bonds aren’t as attractive and their prices must be reduced if they are to attractive to potential purchasers.  So, it’s not much comfort to see an extra point in advertised yield only to see a larger percentage loss in principal if interest rates increase. 

When investing, the concept worth remembering – one which many overlook – is ‘total return’.   Total return is a combination of yield (dividends, interest, etc.) plus change in value.

Yield + Change in Value = Total Return

For investors still accumulating assets, portfolio appreciation is achieved primarily through long-term growth, which generally occurs in the equity (stock) portion of the portfolio.  Bonds simply aren’t designed for growth objectives.

Bonds, however, can help achieve other objectives:  Income, portfolio risk management, predictability.

Bond funds can serve as effective tools for portfolio diversification and risk management simply because (1) they represent a different asset class from stocks, and (2) their ease when it comes to portfolio  rebalancing.  Individual bonds aren’t as easy to use when it comes to rebalancing.  There’s an old saying in the bond market:  Buyers buy the market and sellers pay the freight. 

On the other hand, individual bonds may be worthwhile for income or predictability objectives.  Just as many people are used to `laddering’ CDs, the same can be done with bond.  The fact that individual bonds have maturity dates also adds to predictability.

As you are probably aware, interest rates and bond yields are terribly low these days, so many investors have a tendency to `shop’ for the highest yields they can find.   The thing to remember is that all bond managers shop for bonds in the same bond market.  When they increase yield, they’re generally sacrificing portfolio stability.  

There are only two ways to add yield; they are (1) buy lower-quality, or (2) buy longer maturities, both of which add to volatility risk.   I’ll never forget someone fifteen years ago saying to me, “I didn’t know you could lose money in a long-term U.S. Government bond fund.”   I think he lost around 20% of his original investment, but he did save 1% in advisory fees.    He didn’t realize that in order to  add stability, he needed to limit maturities and stress quality – it also helps to have a maturity date as a backstop. 

Fund turnover is important too.  They bring hidden costs, but we’ll talk about that tomorrow.

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Written by Jim Lorenzen, CFP®, AIF®

January 10, 2012 at 8:05 am