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Lessons for investing in bond funds

Stocks in this article: JNK

By Bill DeShurko

bonds

In my last post for Marketwatch, I made the argument that while bond mutual funds were a likely loser in a rising interest rate environment, individual bonds could still add stability, interest payments, and even capital gain potential.

Simply, if interest rates rise modestly, say by 1 percentage point for the 10 year Treasury note, bond mutual funds will likely have to sell off holdings — at a loss, to meet redemption cash flows. In addition, for funds that target a specific average maturity, short-term bonds (least risky with rising rates) must be replaced with longer-maturity bonds (most interest rate risk) to maintain a target maturity. This presents a conundrum to the investor looking for asset allocation protection from their stock holdings, or a lower risk (than stocks) but higher return option for cash holdings.

While I am not of the opinion that rates will skyrocket, we are sitting at about a 2.8% yielding 10 year Treasury vs. a historic long term average of about 5%. Seems prudent to expect maybe a 3.5%- 4% or so 10 year yield in a post-QE world.

U.S. 10-year Treasury note yield

^TNX Chart

^TNX data by YCharts

With that thought in mind, and my view that bond funds are not the place to be, I’ve been looking hard at bond funds that are held by prospective investment clients. I was a more than a bit surprised by a few things that I found — and facts the owners of the funds were not aware of.

High yield isn’t so high yield

I typically use a position in the SPDR Barclays High Yield Bond ETF (JNK) to boost yield in my Dividend and Income Plus portfolio at Covestor and for accounts managed at our office. However, I sold that position months ago as I wasn’t happy with the 6.5% yield the fund offered at that time.

Recently I reviewed a holding from a client’s mother’s account. She had nearly 60% of her account in a high-yield bond fund which is broker-sold with front-end load fees. The SEC 30 day yield was only 4.47% as reported by Morningstar. Hardly worth the risk for a portfolio with a “junk” average credit rating. Compare that to a taxable muni bond, Aa2/AA- rating, maturing in 2024 with a yield to maturity of 4.341% which was being offered at the same time I was reviewing the fund.

Yes, a fund is diversified, but what’s the point of diversifying with risky assets? I’d much prefer a non-diversified portfolio (10 to 15 holdings) of investment-quality bonds for the same yield. If looking at, or holding any mutual fund with the words “high yield” in the name, remember that is synonymous with the term “junk” — you are not buying quality. Make sure you are being paid adequately for the risk.

Muni bond funds: Don’t assume safety

In this case I was reviewing a financial planning client’s holdings. The funds were no-load, low expense and invested in tax-exempt intermediate-term bonds and tax-exempt long-term bonds. The funds did not have the term “high yield” in their names. Therefore, I assumed, that these were pretty high-quality offerings, and I would simply be pointing out the pros and cons of individual bond ownership vs. mutual funds. You know what they say about “assume?”

Looking at the top 10 holdings, the average credit quality was a BBB, a 17.18 year average maturity, and the second-largest holding was in default. I wouldn’t have a huge problem with this, if the fund marketed itself as a high-yield fund, as obviously a good portion of the fund lies in the “junk” category. By comparison, I could potentially match the average maturity, lower duration, and provide a tax free 5.2% with a portfolio of 10 AA and A rated bonds. Again, I have to ask, why diversify if diversification only increases credit risk?

The same company’s intermediate-term tax-exempt fund fared even worse. In this case one of the top 10 holdings, a Tobacco Revenue Bond, is listed as “distressed,” the yield to maturity of the top 10 holdings is 3.631% with a duration of 7.981, and average rating is “A” with 29% rated BBB or lower. For comparison, I believe a portfolio of 20 individual bonds could have been put together with the same average maturity, almost half the duration of 3.55 years, yield to maturity of 5.983%, and 95% of the portfolio rated AAA and AA.

Lessons to learn

  1. Don’t make assumptions about a fund’s quality, or suitability for your purposes based on fund family reputation alone.
  2. Expenses have a large impact on any fund’s yield. In most cases a fund’s expenses directly reduce the income available to pay out to you, the investor. Most of the difference in yield between the low cost ETF JNK and the load mutual fund could be attributed to the fund’s higher expenses.
  3. While credit quality may give an idea of default risk, interest rate risk is found in a statistic noted in this article called duration. Simply, duration is a measure of how much a fund’s price will move with interest rates. With the probability of rising interest rates you want the lowest duration figure when comparing potential investments.

While a fund’s prospectus will have some answers for you, much of the information can only be found by doing additional research. If you don’t feel qualified yourself, or simply don’t want to take the time, ask for professional help. A Registered Investment Advisor (RIA) has a fiduciary responsibility to act in her client’s best interest. But even if an RIA is objective, it doesn’t mean they understand bonds and bond funds — ask about their bond experience specifically before agreeing to their fee. For many investment advisors, bonds are simply a buy-and-hold investment. While that may have worked in the past 30 years of falling interest rates, it will take more work to preserve capital and make gains in a rising interest rate environment.

Photo Credit: SalFalko

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. The investments discussed are held in client accounts as of October 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

Bill DeShurko

Bill DeShurko

401 Advisor, LLC is a registered investment adviser based in Centerville, OH. Bill DeShurko founded 401 Advisor, LLC in 2003

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