With credit markets frozen, most bond mutual funds have been clobbered. During the month ending Oct. 9, the average high-yield bond fund dropped 15.5%, while Inflation-protected funds declined 7.2%, according to Morningstar. Even low-risk intermediate municipals fell 5.6%. Seeing the carnage, some investors have dumped their fund shares, concluding that it pays to own individual bonds instead of bond mutual funds. When you hold a high-quality bond, you are likely to receive the principal back on the maturity date, they think. In contrast, mutual funds provide less certainty. When rates rise, fund share prices tend to fall. Because the prices fluctuate, you can never be sure what the value of your holding will be on any day. But for most investors, bond funds remain the best choice. Individual bonds have posed special risks in the downturn. For starters, it has become very difficult for retail investors to trade bonds in recent weeks. With markets frozen, there have been few new issues of municipals or corporate securities. Investors seeking to sell their bonds have found few takers. To unload small municipals, investors have been forced to take haircuts, selling bonds at big discounts. Meanwhile, bond mutual funds have continued to trade smoothly. Investors seeking to buy have gained immediate exposure to bonds at low prices. Panicked shareholders who wanted to sell have faced few problems in making redemptions and obtaining cash. In addition to providing easy access to fixed-income securities, mutual funds can deliver higher returns for retail investors. To appreciate why, consider how investors fare in the kind of falling markets that we have experienced lately. With investors dumping bonds in the past year, prices have fallen, and yields on many issues have climbed. For example, yields on 10-year investment-grade municipals have risen from 4.0% to 4.2%.
Suppose an investor owns a $1,000 bond that yields 4%. Twice each year, the investor can receive an interest payment of $20. If rates rise to 5%, the investor may seek to reinvest the interest in a new bond with a higher yield. But to obtain the $1,000 needed to afford the bond, the investor may have to save the interest payments for months or years. While waiting to make the purchase, the investor could be forced to hold the cash in a low-yielding money-market fund. In contrast, a bond fund receives interest payments constantly -- and immediately reinvests the cash in high-yielding securities. Because of reinvestment, fund shareholders do particularly well during periods of rising rates, according to a study by Vanguard Group. In the study, Vanguard uses the example of an investor who holds a fund for seven years. In the first year, rates climb from 4% to 5%, and the fund loses 0.8%. The next year rates climb another percentage point. Though bond prices drop, the fund gains the advantage of reinvesting interest payments at higher rates. The higher yields more than make up for the drop in share prices. And after seven years, the fund would have produced an annual return of 4.2%, Vanguard says. Meanwhile, someone who bought a seven-year bond at the beginning of the period would probably achieve a return of 4%. To outdo individual bonds by a wider margin -- and take more risk -- consider closed-end funds. These trade on exchanges like stocks and own portfolios of securities. The closed-ends often sell at premiums or discounts to the value of their portfolio assets. In the past year, the discount on the average fund has increased from around 1% to 10%, according to the Herzfeld Closed-End Index. When a fund sells for a 10% discount, you can buy $1 worth of assets for 90 cents.
To bargain shop, consider MFS Intermediate Income ( MIN), which sells at a discount of 14.5% and yields 10.1%, according to ETFConnect.com. As recently as last May, the discount was 7.3%. The fund invests in securities backed by the U.S. and foreign governments. More than 90% of assets are in bonds that are rated AA or AAA. Tax-free investors should consider Pioneer High Income ( MAV). The fund yields 8.7% and sells for a discount of 5.9%. In August, Pioneer commanded a premium of 2.1%. Make no mistake. The bond markets may be rough for months to come. But investors who scoop up depressed funds now -- and patiently wait -- could achieve rich returns.