Bond Funds

High costs for individuals make these a bad bet. And the industry has a history of dishonesty in advertising these products. Leave them to pension funds.

Bond funds have the same legal structure as their equity-based equivalents. But they contain bonds instead of equities.

Should you buy them?

All pension funds are stuffed with bond funds. Most pension funds are professionally managed. What's good for them must be good for you surely?

We have four fundamental objections to bond funds for the simple investor:

  1. Bond funds are complicated. This would not matter if the industry could be trusted to sell them properly, but they have, in the past, taken advantage of a lax disclosure regime to persistently misrepresent the attributes of funds. More on this below.
  2. You have even less ability to pick a decent bond fund than you do to pick a decent equity fund
  3. The costs are too high. Pension funds are charged reasonable fees. You will not be.
  4. You have at your disposal a decent alternative, which is a mix of equities (risky) and cash (not very risky) to give a something which is fairly risky. Why complicate your life by having to manage a completely new asset class.

To quote the Financial Times: "There are concerns that investors are not always aware that their income and capital are at risk when they put money in a corporate bond fund or of the extent to which that risk varies depending on the type of bond the fund invests in".

What's in a yield?

You need to understand all the different yields.

Unless a prospectus describes a yield precisely you are potentially being mislead. Here are some possibilities:

  • Fund groups are fond of quoting a 'current annual yield'. This has little meaning on its own: the 'yield to redemption' means more. It's quite easy to bump up the current annual yield without changing the economic position of the fund by investing in bonds with a coupon higher than current market yields (which will therefore cause the bonds to be priced above par). The loss to redemption will offset the high current yield to bring the yield to redemption to its market value.
  • Any yield is good or bad depending on the average duration of the fund - in other words the fund's position on the yield curve.
  • Any yield number is irrelevant unless it's related to risk. The yield on a bond is a reflection of its default risk. The yield on a Walmart bond will be low. The yields on the bonds of Transafrican Mining PLC or Upper Ruritania will be high. The difference between the yields on Walmart and Transafrican could easily be 5%.
  • You might think that a fund's investment objectives or principles would give some guidance on risk. Here's a typical one: "The fund invests in a range of investment grade and high yield corporate bonds". In other words, all bonds.
  • Charges!

Charges!

Do not think that the stated yield is necessarily the income available to the investor. There are still charges to come. These might include:

  • an initial charge (0-5%),
  • annual management fee (1.25%-1.5% per annum for a general bond fund, more for a specialist fund),
  • other administrative expenses (rarely mentioned in prospectuses, might be about 0.25%),
  • dealing costs (never mentioned in prospectuses).
  • defaults

Fees can be charged to capital

This is a smoke and mirrors accounting affair that allows promoters to say that fees will not reduce your income. Well, maybe, but in that case they will reduce your capital.

But are they a good buy?

Look at it this way. The risk premium of a good quality corporate bond over a government bond ('gilts') may be 0.5%-1%. So what's the point of taking extra risks to earn 0.5%-1% extra return and then paying someone else 1.5%-2.5%? You end up with less than you started! And more risk!