No. of Recommendations: 6
Bond Funds

What Are Bond Funds?

• Bond funds are mutual funds that invest in bonds.

• As with other mutual funds, investors purchase shares in the fund at the share price (Net Asset Value for traditional funds) at the time of purchase (end of day for traditional funds, exact time for Exchange Traded Funds).

• The Net Asset Value (NAV) is based on the total value of the fund's assets at the time shares are purchased divided by the number of shares in the fund (which for mutual funds increase or decrease as shares are bought and sold).
---In the case of a bond fund, most of these assets are bonds and the value of these bonds is based on what they would sell for on the open market at a given time or end of day.

• Because the salable values of bonds fluctuate with changes in interest rates and default (and call) risk, bond fund NAVs go up and down.
---We should not expect a steady, if volatile, increase in NAV over time, as is the hope with stock funds (and balanced funds).
---This means the listed historical returns on bond funds (e.g., 1-year, 5-year, 10-year returns) are very misleading, especially if there has been a considerable change in interest rates from the beginning to the end of the period.

• You need to look at both the “income return” (dividends) and “capital return” (change in NAV plus “realized capital gains” paid out as distributions).
--- The “income return” reflects the average yield of the fund for the period and may be assessed in relation to the historical yields for bonds similar to those held by the fund.
---For “capital return,” it is important to understand that you can't expect a significant gain over the long term, unless your starting point is historically exceptionally high interest rates (as in the 1980s).
---If your starting point is exceptionally low interest rates, you do need to worry that the NAV (plus realized capital gains) may never again be as high as when you bought your shares.
---Finding information on the breakdown of “income” and “capital” returns is not always easy and may require reading old annual reports from a fund.
---Vanguard does provide information stretching back over a decade (or the fund's inception) on its web site, if you look under “Performance” then click on “Cumulative…Returns” for a specific fund. For the Total Bond Market Index Fund, see:

• Bond funds pay dividends, per share, based on the dividends paid by the bonds held by the funds, minus expenses (divided by the number of shares).
---The dividends include the premium or discount for bonds not purchased at par by the fund.

• For most bond funds, dividends are paid at the end of each month and can be reinvested in the fund or paid into another fund (typically a money market at the same brokerage) or into an account elsewhere.

• Bond fund dividends are taxed as ordinary income at your marginal federal tax rate (tax bracket) in a taxable account—these are not “qualified” stock dividends eligible for the 15% rate.
---Bond fund dividends from Treasuries are exempt from state and local taxes in taxable accounts. (The fund should provide a breakdown of what % of dividends is from Treasuries at the end of the year.)
---Dividends from Municipal (“tax-exempt”) bond funds are exempt from federal taxes.
---Municipal bond fund dividends that derive from bonds issued in your state are also exempt from state and local taxes. (If you use a general “muni” fund, with bonds from many states, the fund should provide a breakdown of what % of dividends come from each state.)

• Bond funds list a 30-day “SEC yield.”
---This is supposed to give a snapshot of the dividends paid by the bonds held by the fund over the past 30 days, less fund expenses, averaged over the number of shares, divided by the share price, projected forward and compounded over 365 days.
---SEC Yield is a one-year compounded yield, comparable to the Annual Percentage Yield of a CD or the adjusted-current-yield of a bond (with one year's worth of compounding), not to the Yield-to-Maturity of a bond. (If you are comparing a fund's yield with a bond whose coupon is considerably different from prevailing yields, you should use YTM and project the compounded SEC yield forward to the bond's maturity, divided by time to maturity, as with comparing a multi-year CD with YTM.)
---SEC yield is what you are supposed to receive for the next 365 days, not for the current year. For example, if you looked at a bond fund's yield on July 15, 2006, you were being told what to expect between that date and July 15, 2007, not what you should expect for the entire year of 2006.
---Because the SEC yield is after expenses, it helps compare similar funds from different fund companies. This is the main goal of the SEC, not providing a basis for comparison with buying individual bonds or CDs or different kinds of funds.
---Like the yields on Money Markets, the SEC Yield on bond funds changes; in fact, it changes daily.
---Since it projects forward by assuming bonds owned the fund will be replaced by bonds at prevailing interest rates, at any given moment it will almost certainly be incorrect as a measure of what you will actually receive in dividends over the next 365 days, because prevailing interest rates keep changing.
---Although SEC Yield is based on the last 30-days' dividends, it is forward-looking, making assumptions about what dividends will be paid by new bonds that replace old bonds. As a result, the actual monthly “Distribution Yield” (monthly per share dividend payment divided by the reinvestment share price, projected forward for 365 days) may be quite different from the SEC Yield. This is not simply a matter of one yield being compounded and the other not. There is a lag time before old bonds are replaced. During periods of rising interest rates, the SEC Yield should be expected to exceed the Distribution Yield, while the opposite should be expected during falling interest rates. This discrepancy is greatest with short-term bond funds, because the replacement cycle for bonds held by the funds is shorter.
---For more on SEC Yield, see:

What Kinds of Bond Funds Are There?

• Bond funds are available that specialize in most maturities and types of bonds, as well as many funds that represent cross-sections of the bond market or the market as a whole.

• Bond funds also vary as to whether they take an index investing approach (using one of the Lehman bond indices), a buy-and-hold bond picking approach, or a more aggressive bond trading approach (including, in some cases, leveraging).

• The broadest funds buy bonds across most bond categories (different maturities, Treasuries, corporate bonds, mortgage bonds), except municipal bonds and, in many cases, “junk.” (Some bond funds, unless specifically designated as “high-yield,” are not allowed to own junk bonds and may be required to sell bonds they own that are downgraded to junk.)

• Some funds specialize by maturity (maturity ranges listed below are approximations):
---“Ultra-short” bond funds have average maturities in the 3-month to 6-month range.
---Short-term bond funds have average maturities in the 2-3 year range.
---Intermediate-term bond funds have average maturities in the 5-8 year range.
---Long-term bond funds have average maturities in the 15-20 year range.
---Typically, funds with shorter average maturities have lower dividends/yields.
---Funds with longer average maturities also have longer average “durations” and are more susceptible to changes in (relevant) interest rates.

• Funds may also specialize by type of bond:
---Treasury funds own Treasuries.
---Inflation-Protected Treasury funds own TIPS.
---Corporate funds mostly own corporate bonds, often excluding junk bonds.
---High-Yield Corporate funds mostly do buy junk bonds, though they vary as to how far they venture into the lowest junk ratings.
---GNMA funds invest primarily in GNMA bonds.
---International Bond Funds mostly invest in international bonds, though some hedge with U.S. bonds and they differ on how much, if any, they delve into emerging markets debt.
---Tax-Exempt funds invest in municipal bonds, sometimes limited to insured Munis.
---Some state specific municipal bond funds are also available, though mostly for high tax states.

• Some funds specialize by both type and maturity, such as a Long Term Corporate fund or a Short Term Treasury fund.

• Vanguard offers a wide range of no-load, low expense bond funds, which will give a sense of what is available:
---Other fund families may have options not provided by Vanguard, such as “ultra short” funds, stock picking funds that try to beat the Lehman Total Bond Market Index, more aggressive junk bond funds, and a range of actively managed bond funds, including some that make extensive use of leveraging to increase returns (with concomitant risks).

What Are the Expenses to Owning Bond Funds?

• Like other mutual funds, bond funds have expense ratios that eat up some of the dividends (or capital gains) generated by the fund.
---Expense ratios vary considerably between fund families and sometimes between funds within a fund family.
---Bond index funds typically having lower expense ratios, although the differences from conservative select funds may be small. (For example, Vanguard's Short Term Index Fund has an expense ratio of .18%, its Short Term Corporate Fund, .21%.)
---Bond funds from some fund families come with loads. In case you don't already know this, “back-end” loads do not just disappear—if you don't pay the load up front, you will have a higher expense ratio to make up for it.
---Bond funds that trade frequently will generate higher trading expenses than those that don't, and they may have capital gains that are taxed in taxable accounts.
---In some cases, there may also be other fees, such as low balance fees or, with some brokerages, 12-b-1 fees.
---As a bottom line assessment, if you want a portfolio that includes bonds that can only be bought on the open market and have a relatively small amount of money to invest per bond (e.g., buying in $1000 increments), the expenses on a low cost bond fund will probably be lower than your costs to buy bonds on your own.
---If you are buying Treasuries at auction or are buying in large increments, you will have lower costs on your own.

Are There Minimum Investment Amounts for Funds?

• All Bond funds do have minimum initial investments and minimum additional investments.

• For example, as of January 2006, Vanguard has minimum initial investments of $3000 on both taxable and IRA accounts, with $100 additional purchases.
---TIAA-CREF has a $2500 minimum, with $100 additional purchases. However, TIAA-CREF has an automatic investment option that allows for initial and subsequent investments of $50:

• Exchange Traded Bond Funds do not have minimums, but do charge commissions per transaction.

What Are the Advantages of Bond Funds Over Individual Bonds or CDs?

• As with other mutual funds, bond funds provide instant diversification.
---This means funds have the potential to provide higher yields than people of moderate means can get for themselves, because funds can spread out the risk of buying lower rated corporate bonds that might be too dangerous for individuals who can only afford to buy a few different bonds.
---Also, funds can buy higher yielding bonds of longer maturities than are practical for those who will eventually need their principal back, a point that is mostly relevant to long-term bond funds.

• The expense ratios on low cost funds are lower than the costs of buying bonds on the open market in small increments.

• After an initial minimum investment, shares in bond funds can be bought and sold in relatively small increments (e.g., $100 instead of $1000 per bond).

• Bond fund shares can be bought any time.
---This is also true (more or less) of buying bonds on the open market, but if you want to buy at auction or buy a new issue, you have to wait until the particular issue you want is available, which may happen infrequently.

• Bond funds have full and easy liquidity.
---You can always sell your shares, when you need money, even if sometimes at a loss.

• Because bond share prices fluctuate with interest rates, if interest rates fall, you may be able to sell your fund shares at a profit.
---This will usually be most true for long-term bond funds, which are also the ones most at risk of losing money if interest rates go up.
---Tradable bonds, but not regular CDs, can also be sold for a profit when yields fall, though you will have to pay a commission, and holding a portfolio of long-term bonds, from which the profit would normally be highest, may be undesirable for other reasons.

• For people with strict asset allocation plans, it is much easier to rebalance on a schedule using bond funds for the bond/fixed-income allocation(s).
---The disadvantages of bond funds may however outweigh any “rebalancing bonus,” especially during periods of low interest rates, when interest rate risk and refinancing risk are high.

• For many 401(k) and 403(b) plans, bond funds are the only non-stock options available, other than money markets—this hardly can be considered an advantage, but it is a common reality.
---Those who have restricted employer-sponsored retirement plans may want to consider rolling the money into a Traditional IRA when changing jobs or upon retirement to have the option of choosing buying individual bonds and CDs, as well as funds.

What Are the Advantages of Individual Bonds and CDs Over Bond Funds?

• If you periodically buy bonds and CDs on your own, you can often get better yields for similar maturities and default risk than what is available through funds.
---Having access to 5-year CDs from a variety of institutions is a big plus compared to intermediate bond funds with high proportions of Treasury Notes.

• As with other mutual funds, diversification does water down potential returns as the flipside of protection from the devastating losses associated with a concentrated portfolio.
---A conservative investment grade corporate bond fund will have a lower yield than you can get on your own with low investment grade bonds, and you would have to look for a very aggressive junk fund to get the returns you could potentially get with junk bond picking and trading.

• By buying individual bonds you can lock in yields when they are high, while bond fund yields will fall with lower interest rates.
---Recognizing high rates is an educated guess, but it is educated.

• If you are able to buy individual bonds cheaply, such as TIPS and Treasuries at auction, your expenses should be lower than even those of low cost bond funds.

• Most importantly, by buying individual bonds and having the option of holding to maturity, you can avoid some of the trading risks associated with bonds that for bond funds are unavoidable. (Some aggressive funds do try to avoid these risks with market timing and bond selection, but they will charge you quite a bit more than conservative funds.)
---On the other hand, if you do include tradable bonds in your bond/fixed-income portfolio, you can take advantage of trading opportunities, so you are in something of a win-win situation, or more accurately a no lose-win situation.
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