Bond funds tout professional management and diversification as their advantages over buying individual bonds. Let’s look at both.
– If you buy a bond and hold it to maturity, what’s there to manage? In any event, the 1%+ annual management fee is too much. If the underlying bonds yield 3%, you will get 2% – a 1/3 reduction in income!
– To compensate for the yield shortfall and/or to compete against other bond funds, your fund may use options, derivatives or leverage, subjecting you to more risk than you might think.
– Predicting interest rates is notoriously difficult. Bond fund managers make plenty of mistakes. Their mistakes are your loss.
– Most bond funds are managed by large institutions which often stuff junk from their corporate clients that nobody else wants into fund portfolios.
Diversification supposedly protects you against defaults as theoretically any bond can default at any time. BUT:
– The US Government has never defaulted on its obligations, and if it does, we will all have bigger problems. So a US Government bond fund is a total no-no. Just buy government bonds outright. If you buy them direct from Treasury Department, there is no commission.
– Some corporate and municipal bonds are insured as to the timely payment of interest and principal. As long as the insurer is sound, your bond is safe, although you get less interest.
– Many blue chip companies issue bonds: Boeing, Coca Cola, Wal-Mart. Theoretically, any company can declare bankruptcy (GM did!). But since corporate bonds trade in $1,000 increments, it’s easy to construct a diversified portfolio of high quality corporate bonds, limiting your exposure to any one issuer.
– Historically, less than 10% of all bonds default, and most are low quality junk. So the only time you may need a fund is when you are looking to buy junk bonds.
Professional management and diversification can help in a foreign bond fund that deals in hard to get into, hard to evaluate issues otherwise unavailable to retail investors. But a foreign bond fund also adds sovereign risk – the risk of a new government messing up the economy, like Argentina or Venezuela. But in a global economy, where everything is interconnected, what are the chances that you can get a high interest fund somewhere while US interest rates are low? So why bother? Keep your bond/income money in simple and safe instruments while using your risk money in investments with higher return potential, like stocks. The same goes for specialized bond funds, like convertible bonds, etc.
Short-term or intermediate term bond funds? No need to go there either. As a bond nears maturity, it automatically becomes an intermediate and then a short-term bond. Just buy one yourself with a maturity that suits you.