Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP
Bond mutual funds have become very popular in recent months. This month, we will discuss how to pick your own bond funds, as well as some of the pitfalls to avoid.
Bond mutual funds consist of a portfolio of many bonds, a small portion of which mature at any one time. A bond fund does not return principal from maturing bonds to shareholders. Instead, it is reinvested in new bonds. This means that no matter how long you hold a bond fund, there is no guaranteed return of principal.
The same interest rate factors that affect the performance of an individual bond also are true with bond funds. When rates rise, shares in the fund will fall. If rates fall, shares will rise. There is, however, an important difference: With the single bond, you know what your investment return will be (barring credit problems) if you hold it to maturity.
Bond mutual funds have many advantages compared to individual bonds. Investors can start with a much smaller amount and get a high degree of diversification, which is important for avoiding too much exposure to any individual borrower. Also, you can redeem your shares of a bond fund at any time without cost (in a no-load fund). On the other hand, selling individual corporate bonds back to a bond dealer can be expensive.
High-yield bond funds
High-yield, or junk bond, mutual funds are completely different from funds that invest in high-quality debt. High-yield funds pay very tempting levels of interest. However, the volatility of the junk bond market makes them unsuitable for long-term buying and holding. Indeed, despite their attractive yields — in many cases above 10 percent per year — high-yield bond mutual funds have been among the weakest performers in the bond universe in recent years.
How to pick you own bond funds
When you select bond fund investments yourself, answer these questions:
• Is the expense ratio reasonable (i.e., at or below 1/2 percent per year) and is the fund completely free of sales charges?
• How did the fund do during the bond bear market years of 1994 and 1999? (Funds that lost more than 5 percent including dividends during either of those two years may be riskier than necessary.)
• How much has the bond fund returned in the years 2000 through 2002? (The average, intermediate-term corporate bond fund has returned 24 percent total from 1/1/00 to 10/31/02. During the same period, the average short-term corporate bond fund returned a total of 18 percent. Beware of funds with returns below these amounts, including the effect of sales charges.)
Based on their histories and low expense ratios, we recommend that bond fund investors consider these two bond funds: Dodge and Cox Income (DODIX) and Vanguard Total Bond Market Index (VBMFX). Pimco Total Return (PTTRX) also has been an outstanding investment for institutional customers because its celebrated fund manager, Bill Gross, has delivered a better return than the typical bond fund with less risk. If you have access to the institutional class of shares through your investment advisor or retirement plan, PTTRX should be at the top of your list. Other classes of shares more readily available to individual investors have sales charges and higher expenses than the institutional class, making their past performance less attractive than the Dodge and Cox or Vanguard Funds. Of course, past performance does not guarantee any future investment results.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or firstname.lastname@example.org. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.