Radical Guide to Bonds: Should You Buy a Bond Fund?

Some bond funds make eminent sense.  (We don’t have a dog in this fight!).  They give investors exposure to wide and/or narrow swatches of the bond market.  This chapter will flag a couple of points on no-load, low cost indexed bond funds.

But why are we only looking at indexed bond funds? 

We think actively managed bond funds cost too much.  You will receive exposure, but it will come at a price.  By holding an actively managed bond fund, you are banking on future excellent performance in return for higher upfront and ongoing costs. 

Additionally, current trading gains distributed to you in these funds can be a tax liability cost.  Trading costs in the fund are passed on to you as a shareholder.  Both these costs depress your after-tax current returns and, subsequently, compounded future returns. 

Unfortunately, hard as we try, the realized costs of indexed funds can be murky, too.   Here are two considerations on the costs of indexed bond funds:

  • Indexed bond funds turnover their holdings, too, like actively managed bond funds. Through resets to match the index, bond redemptions and other shareholder redemptions, it’s not surprising that indexed funds turnover.  You will not completely avoid turnover costs in an indexed fund ---- such as the trading and after-tax costs of gains distribution discussed above.

However, you should expect the turnover to be lower on indexed than on active funds.  This thought begs the question:  What is the range of annual turnover on indexed bond funds? 

Yahoo! Finance will give you a good profile of historic turnover rates versus the category average.  For indexed bond funds tracking the Lehman Aggregate Bond Index (the bond market’s broad-index standard), most funds reported turnover in the 50-75% range.  Remember that past turnover is no indication of future turnover!

  • All indexed bond funds costs will not be disclosed to you, upfront, before you purchase the fund. The annual expense ratio includes all the annual operating fees.  The annual distribution, marketing, 12b-1 fees and other overhead expenses should be captured in that ratio.  The ratio will likely be around .20% for a low cost, broad-based indexed fund. 

However, the fund’s trading costs --- and other incidental brokerage costs to the fund --- will not be included in the ratio.  As more trading occurs in the bond fund to match the index, the costs are passed on to you as a shareholder.  Trading costs are only known to you after the fact!

You may know this already, but it is worth repeating.  Funds report these additional brokerage costs (as a percentage of assets) in the Statement of Additional Information filed with the SEC.  You can request a copy from the fund company directly.

With the introduction of ETFs in the 1990s, shareholders were protected from unwanted trading gains, one of the problems discussed above.  ETFs solved one of these problems related to the structure of funds, but not all. 

Please read on as we discuss how ETFs are applied to the universe of bonds.

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June 3, 2005 | Permalink


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Loved this article.
I do preffer bonds directly, or funds that buy and hold the bonds.

I am not a short term trader of bonds.

Thanks for the website,

-- Jose

Posted by: Jose | Jun 19, 2005 3:24:11 PM

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