Part 1:Prometheus Bond

Bond fund management is not known for clever and novel ideas– at least, not well known. Active management with aggressive timing of maturities and different credits, option-writing, other uses of derivatives–all seemingly offered the potential for improved returns or yields with limited risk. Some delivered. Some flailed. Some failed.

Enter the exchange-traded fund (ETF) concept. While ETFs have been around for almost a decade, growing remarkably popular over the last three years, the first bond ETFs emerged this summer (July 26, 2002, to be precise). As advisors, we need to ask some very basic questions. Are they just the latest bond gimmick? If they’re so great, why the delayed introduction? And why pay a brokerage commission on an ETF bond index investment, when good no-load bond mutual funds abound?

Some analysts have pooh-poohed the concept of a bond ETF, because the ETF’s ability to minimize capital gains distributions is not as important for a bond fund as for a stock fund. (Most bond return comes as income, not capital gains, which must be distributed whether held in an ETF or a mutual fund, although bond funds can realize gains when interest rates are falling.) But the ETF’s structure has other advantages; minimizing fund expenses and trading costs are actually more important for bonds than for stocks.

How to Get Higher Returns

Apart from working to minimize taxes (e.g., by maximizing 401(k) contributions or buying municipal bonds), there are three basic ways to get higher returns in your income portfolio:

1) Go long. Usually the yield curve is positive, meaning long-term rates are higher than short-term. (The opposite situation, short rates higher than long, is what is known as an inverted yield curve.) One can pick up yield by moving from a money market fund to short-term bonds, then to intermediate- or long-term bonds. Risk also goes up with each step. When interest rates rise, long-term bonds lose the most. (Typically, a bond with 10-year maturity has a duration of seven, meaning if rates climb one percentage point, it will lose 7% in value.)

2) Take on credit risk. High-quality corporate bonds have higher yields than U.S. Treasuries; lower-quality corporates have even higher yields, with junk bonds (those rated below BBB) yielding the most. The lower a bond’s quality, the higher the issue-specific risk of company default and the loss of some or all value. One can reduce issue-specific risk with a diversified portfolio and good fund management, but junk bonds, just like stocks, always have broader risks of falling collectively in a downturn. That said, investment-grade corporates always yield more than Treasuries; a well-constructed portfolio of investment grades should beat a comparable Treasury portfolio over time with little or no added portfolio risk.

3) Lower investment expenses. This is the only free lunch. Money you don’t pay your fund company is money you keep, risk-free.

Should fund expenses always be considered “lost money?” No. Active management has a place in junk bond portfolios and emerging markets bond portfolios, just as it has in portfolios of stocks, especially illiquid, inefficiently priced stocks. Where securities from different companies show varying returns and prices are inefficient, a manager can pick the overlooked and undervalued; some managers have shown solid records of long-term outperformance.

But for more efficient markets, especially Treasury bonds where credit issues don’t come into play, but also for larger, high-quality corporate bond issues, active management adds little, and can’t make up for correspondingly higher expense ratios compared to index investing.

Why Index?

If you pick a bond fund now from among all taxable funds, based on past performance for, say, five years, you’ll be led to the longest-term bond funds, most of which are invested in Treasuries or high-quality corporates. That’s because long-term interest rates have been dropping during this period, so we’ve been in a bond bull market–especially good for the bonds most sensitive to rates. Of course, this is also the area that will get hit the hardest if longer-term rates climb back.

The recent historical advantage of longest-term bond funds has less to do with fund management skills than with fund objectives. And as an advisor, you can’t really judge relative performances of two or more funds without limiting comparison to those with similar maturities and credit qualities. For higher-quality bonds with similar maturities and credit qualities, most return variation is due to differences in fund expenses. So the investment-grade (and government) domestic bond market calls for low-cost index investing.