In an article published today in the Wall Street Journal, entitled "The New Bond Equation," the author attempts to educate readers about the potential risks involved in investing in bond mutual funds, given the current economic environment. He writes:
"As the financial crisis heads into its third year, investors in bond funds are facing some difficult choices. Investors usually turn to these funds for safety. But bond funds are facing a host of pressures that are driving down returns, raising long-term risk—and making it tougher to settle on the right investment strategy."
While I agree with the author's statement above, he makes some statements that mislead bond investors. (Click here to read the full article.) For example, he writes:
"....they’re buying vehicles that invest in intermediate-maturity bonds. These funds also typically hold a mix of government, mortgage and investment-grade corporate bonds, which spreads risk around. Even cautious intermediate-bond funds yield about 4%, handily beating rates available on money-market funds."
This quote above is comparing apples to oranges, as these investments have completely different risk levels. Of course an intermediate term bond fund will yield much more than a money market fund. Investors face the risk of rising interest rates when they hold longer term bonds. The more rates rise, the more their longer term bonds suffer price declines. For this additional risk money market investors don't face, intermediate bond investors expect a higher return over time.
Further, in the article the author initially talked about buying long-term treasuries as a very safe bet. He really misled readers about the risk and corresponding volatility involved, ignoring interest rate risk and price fluctuations. However, the author did later explain how these fluctuations occur and provided a good description of bond duration, which investors or their investment advisors need to understand. In an oversimplified explanation, think of duration as how long it takes to get your money back from the bond. The larger the duration the longer it takes to get your money back and thus the more interest rate risk inherent in the bond or bond fund.
To provide a real-life example, VUSTX (Vanguard Long Term Treasury) has a duration of 11.6 and a standard deviation of 12%, which a measurement of how volatile the investment is. Comparatively, VFISX (Vanguard Short Term Treasury) has a duration of 2.6 and a standard deviation of just more than 2%--a much less volatile and thus a 'safer' bet than it's long-term counterpart. As rates change, there is little lag with the short-term rate bond fund, so the volatility is much, much lower. Longer term rates aren't quick to change and thus their price fluctuates much more, causing increased standard deviation.
A reader posted a comment that makes an argument that individual investors should use individual bonds rather than bond mutual funds. However, investors must be careful in purchasing individual bonds. Transaction costs to purchase bonds on the secondary market are quite high for smaller denomination bonds, making a low cost mutual fund and its institutional purchasing power less costly net of fees. Further, most investors purchasing individual bonds will be resigned to treasuries and AAA-AA municipals, as they can't afford to purchase enough riskier bonds to gain adequate diversification of credit risk. The same isn't true for a low cost bond mutual fund.
In short, keep your bonds 'short and sweet', meaning short duration and high credit quality. A low cost bond fund with these characteristics will serve you just fine, but if you have substantial assets, you could purchase individual bonds and get a bit more control of your bond / income portfolio. However, a mutual fund may still be preferable because of the diversification, liquidity, and simplicity it yields for the investor.
To Your Prosperity ~ Kevin Kroskey
"As the financial crisis heads into its third year, investors in bond funds are facing some difficult choices. Investors usually turn to these funds for safety. But bond funds are facing a host of pressures that are driving down returns, raising long-term risk—and making it tougher to settle on the right investment strategy."
While I agree with the author's statement above, he makes some statements that mislead bond investors. (Click here to read the full article.) For example, he writes:
"....they’re buying vehicles that invest in intermediate-maturity bonds. These funds also typically hold a mix of government, mortgage and investment-grade corporate bonds, which spreads risk around. Even cautious intermediate-bond funds yield about 4%, handily beating rates available on money-market funds."
This quote above is comparing apples to oranges, as these investments have completely different risk levels. Of course an intermediate term bond fund will yield much more than a money market fund. Investors face the risk of rising interest rates when they hold longer term bonds. The more rates rise, the more their longer term bonds suffer price declines. For this additional risk money market investors don't face, intermediate bond investors expect a higher return over time.
Further, in the article the author initially talked about buying long-term treasuries as a very safe bet. He really misled readers about the risk and corresponding volatility involved, ignoring interest rate risk and price fluctuations. However, the author did later explain how these fluctuations occur and provided a good description of bond duration, which investors or their investment advisors need to understand. In an oversimplified explanation, think of duration as how long it takes to get your money back from the bond. The larger the duration the longer it takes to get your money back and thus the more interest rate risk inherent in the bond or bond fund.
To provide a real-life example, VUSTX (Vanguard Long Term Treasury) has a duration of 11.6 and a standard deviation of 12%, which a measurement of how volatile the investment is. Comparatively, VFISX (Vanguard Short Term Treasury) has a duration of 2.6 and a standard deviation of just more than 2%--a much less volatile and thus a 'safer' bet than it's long-term counterpart. As rates change, there is little lag with the short-term rate bond fund, so the volatility is much, much lower. Longer term rates aren't quick to change and thus their price fluctuates much more, causing increased standard deviation.
A reader posted a comment that makes an argument that individual investors should use individual bonds rather than bond mutual funds. However, investors must be careful in purchasing individual bonds. Transaction costs to purchase bonds on the secondary market are quite high for smaller denomination bonds, making a low cost mutual fund and its institutional purchasing power less costly net of fees. Further, most investors purchasing individual bonds will be resigned to treasuries and AAA-AA municipals, as they can't afford to purchase enough riskier bonds to gain adequate diversification of credit risk. The same isn't true for a low cost bond mutual fund.
In short, keep your bonds 'short and sweet', meaning short duration and high credit quality. A low cost bond fund with these characteristics will serve you just fine, but if you have substantial assets, you could purchase individual bonds and get a bit more control of your bond / income portfolio. However, a mutual fund may still be preferable because of the diversification, liquidity, and simplicity it yields for the investor.
To Your Prosperity ~ Kevin Kroskey