(PUB) Investing 2015

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14 • Fund Family Shareholder Association
es—so $100 in the future won’t be
able to buy you as much as $100 could
today. Inflation is a cost to all investors.
Say you make an investment, and it
returns 5% over a period when inflation
runs 2%. Your nominal return may have
been 5%, but your real return after
factoring in inflation is only 3% (real
return = nominal return - inflation).
If inflation affects all investors, why
should bond investors be particularly
concerned about it?
Let’s go back to the reason bonds
are also known as fixed-income invest-
ments. Focus on the word “fixed.”
When you buy a bond, you are lock-
ing in a known or fixed level of return
(assuming you hold the bond to matu-
rity). But inflation can change over
time. If you buy a bond with a 3% yield
and inflation is running at 1%, your real
return should be 2%. However, what
if inflation actually rises to 4%? Now
your real return will go negative—from
2% to -1%. On a real, inflation-adjusted
basis, you’ve actually lost purchasing
power, despite earning a 3% yield.
Since one goal of investing is to both
maintain and improve our ability to
consume in the future, inflation is not
to be taken lightly.
Bonds vs. Bond Funds
To this point I have focused primar-
ily on the mechanics of bonds. But
there are considerations you need to
make when deciding between investing
in individual bonds and bond funds.
The primary difference is the contract
between you, the lender, and the bond
issuer, or borrower. Or, I should say,
the lack of a contract when you opt for
a fund.
As I explained last month, when you
buy an individual bond, you are typi-
cally lending money to a government
or corporation, and there is a contract
which states how much interest you
will receive and when, as well as how
long you’ll have to wait before your
money is returned to you. Assuming
you hold the bond to maturity (the end
of the contract) and the borrower does
not run into trouble and default, there is
not too much more to it.
However, when you buy a mutual
fund investing in bonds, there is no con-
tract. With no guarantee that you will
receive a certain level of income, nor that
your money will be returned to you in
full on a set date, why own a bond fund?
Think of all the reasons why you
might own a stock fund—such as diver-
sification and professional manage-
ment. The same applies to bond funds,
and then some.
Diversifying who you are lending
to gives you exposure to bonds with
different maturities and yields. Plus, it
takes a lot of money for an individual to
build an adequately diversified portfo-
lio of bonds. Bond funds, even more so
than stock funds, bring diversification
to investors of all sizes.
Professional management is another
advantage. Oddly enough, this applies
to both indexed and actively managed
funds. Total Bond Market holds over
7,500 bonds—good luck trying to rep-
licate that on your own. Of course, the
other advantage (or potential advan-
tage) of an active manager is the ability
to separate bond market winners from
losers—to find the best values the bond
market has to offer. When your poten-
tial return is fixed, avoiding the blow-
ups matters all that much more. The
professionals running your bond fund
are also able to negotiate better prices
for the bonds they buy. And finally,
as other investors add money to their
bond funds, the managers can purchase
new securities that may provide higher
yields than those owned when you first
bought the fund. Those higher yields
accrue to you as well as your fellow
fund shareholders.
So which is right for you?
If you have enough money to buy a
diverse basket of bonds and your goals
are a steady, known stream of income
plus complete preservation of capital,
then individual bonds may well be the
way to go. On the other hand, if you are
looking for more diversification or are
investing for total return (both income
and the growth of your principal), then
a bond fund is likely better suited to
meet your goals.
Tough Bond Math
Let’s turn to the question the Barron’s
cover story I mentioned at the top asks:
Is it time to ditch your bond fund?
My answer is an emphatic no. But
I understand why the media is posing
the question and why investors are
concerned. On its face, the math behind
bond returns and rising interest rates
isn’t pretty.
Remember that when we buy a
bond, we are locking in a known level of
return, and by taking into account dura-
tion, we can have a decent idea of what
will happen to our bonds under different
changing interest rate scenarios.
Let’s take a 10-year U.S. Treasury
bond. At the end of June, the yield on
the 10-year Treasury was 2.34%, and
its duration was 9.0 years. The table
below shows what would happen to the
price of that 2.34% bond given various
moves in interest rates. The risk-reward
trade-off, with limited upside and the
potential for lots of pain, is out of
whack from what we typically want
from a supposedly “safe” investment.
Inflation Reduces Returns
6/916/936/956/976/996/016/036/056/076/096/116/136/15
Long-Term Gov’t Bonds
Adjusted for Inflation
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
Sources: Morningstar and Ibbotson.
How Rates Change Returns
If the yield on the
10-Year Treasury
went to…
…its price would
rise or fall by…
0.5% 16.6%
1.0% 12.1%
1.5% 7.6%
2.0% 3.1%
2.3%* 0.0%
2.5% -1.4%
3.0% -6.0%
3.5% -10.5%
4.0% -15.0%
5.0% -24.0%
7.0% -42.0%
9.0% -60.1%
*Yield as of 6/30/15.