Investing In Bond Funds? Follow These Rules Of Thumb

By Thomas E. Nugent

The last time interest rates were as low as they are today, the Beatles were the newest craze in America.

Back then, individual investors used either savings accounts or equities to save for retirement. In fact, most retirement benefits were provided by employers through defined benefit pension plans that provided a reliable income during retirement.

Times have changed over the last 40 years. The shift from defined benefit to defined contribution plans by employers has forced many individuals to take control of building their retirement nest egg.

The many options available do provide unprecedented flexibility, but they also inject an added degree of confusion. One example is the bond mutual fund. These are very popular in periods of stock market volatility, but investors and advisors need to follow a few rules of thumb before plowing hard-earned money into these funds.

Do not let bond mutual fund advertisements and of past returns mislead you. In conjunction with my associate, Warren Bitters, we screened 162 government bond funds listed in the Morningstar database and found that they turned an 8.44% average total return through Aug. 31, 2002.

Thats a good return, especially when contrasted with simultaneous stock market declines. Given these positive returns, many mutual fund companies have heavily advertised their bond funds results. However, these returns may be difficult to duplicate.

Rule 2: Start with the current yields on bonds as a proxy for your expected return.

One factor limiting investors potential return in the current investment environment is low interest rates. The yield on the 10-year Treasury note is slightly below 4%, while the yield on two-year Treasuries is a miniscule 2%. A mutual fund that invests in these securities should yield somewhere in the 2% to 4% range, less administrative and management expenses.

Rule 3: Know the risks of bonds selling at premiums.

Practically all government bonds sell at premiums to the market, because their prices have risen as interest rates have fallen. Bond mutual funds (with the exception of zero-coupon funds) now hold virtually all premium bonds.

When these funds provide historical return calculations, they include that premium. What they fail to include is the certainty that the premium bonds will fall in price to par as they approach maturity. Furthermore, bonds with high coupons have the effect of bolstering the current yield of the fund, making the fund appear attractive to investors, while obscuring the sure loss of principal that would go along with those investments should they be held to maturity.

Rule 4: Scrutinize the expenses of the fund.

The next problem with investing in bond mutual funds is the expense ratio associated with managing the fund. Using the same screen of 162 funds mentioned above, we found the average expense ratio was 89 basis points. That average expense ratio is almost 25% of the yield on a 10-year Treasury or 50% of the yield on a two-year Treasury. In some cases, fund expense ratios may exceed 1.25%.

For funds that charge a sales fee, the net return to the investor is reduced even more. John Bogle, founder of the Vanguard Group, has pointed out that expense ratios can have the greatest negative effect on bond mutual funds, so he recommends searching out those funds with low relative expense ratios.

Rule 5: Familiarize yourself with the history of bond returns.

Buying bond mutual funds in todays low interest rate environment is almost a no-win proposition. Rising interest rates will undermine principal values, while a stable interest rate environment will produce paltry returns, of which fund management fees can take a major share.

Investors and their advisors need to focus on future return potential, not past returns, before investing in bond funds. They also need to recognize that bonds mature, but bond funds dont. Consumers need to know that owning individual bonds means that at some point they will get their money back. You cant say the same about bond funds.

Thomas E. Nugent, is the chief investment officer of PlanMember Services, a Carpinteria, Calif., retirement planning company, based in Hilton Head Island, S.C. His e-mail is tom@wms4you.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 30, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.