Here's what everybody gets wrong about bond funds

Ignore fluctuations and look at the total return of bond funds.

  • By Anora M. Gaudiano,
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When it comes to bonds, the relationship between prices and actual returns isn't quite as simple as that same relationship in the stock market.

Annual nominal bond returns can be positive or negative regardless of rising or falling prices. Over the past 37 years, bond prices have generally risen and each cyclical drop in prices — dubbed as a rising-rate environment — has been mistaken for the bottom.

The great shift from stocks to bonds

Certain evidence points to a marked change in what investors are buying.

This characteristic of bonds only confuses many retail investors, who may be approaching their bond investments in the wrong way, or for the wrong reason.

"Since rates are difficult to forecast and can be quite volatile over the short term, the best course is to keep reinvesting interest payments and resisting the temptation to sell when funds underperform," said Tim Utecht, chief investment officer at Life Planning Partners, Inc. In other words, trying to gain an edge in bond funds from price fluctuation is hard, because returns are driven by inflexible math.

Bonds aren't perpetual instruments like stocks. Bonds are issued with a set maturity and periodic interest payments. Market forces and central banks dictate what current interest rates should be, influencing prices of not only new issues, but existing ones as well. Bond prices and yields move in opposite directions.

One way for investors to improve the chance of positive returns from bonds is to match their holding period with the duration of the bond or the bond fund. Duration is the time it takes for investors to recover their initial investment from the interest payments they collect. Because of interest payments, the duration of a bond is shorter than its maturity: the higher the interest payment or coupon, the shorter the duration and the longer the duration, the more sensitive the bond is to changes in interest rates.

Because of this, most bond funds "ladder up" their bonds, or buy bonds with different maturities, in which interest rates are reinvested in bonds with longer-dated maturities at current interest rates. This strategy gives exposure to the whole yield curve, while allowing investors customize their portfolio for income from cash flows.

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Some bond fund managers use a "barbell" strategy, investing only in the long-dated and short-dated bonds. In a rising-rate environment, this strategy captures the best of both worlds, reinvesting in higher-yielding short-dated bonds. In a falling-rate environment, the long-dated bond prices make up for the shortfall in the lower yields. The barbell strategy is an actively managed portfolio and has higher costs associated with trading.

Keep in mind that while "it is true that actively managed bond funds generally outperform passive funds such as those indexed to Barclays Aggregate, that is because they take more risk by investing in high-yielding junk bonds and longer-dated maturities," Utecht said.

That all may be less relevant than the primary purpose of high-quality bond funds: to buffer stock-market volatility.

Investors, as much as they can, should ignore bond price fluctuations, agreed Philip McDonald, associate director of investments at Symmetry Partners, a Glastonbury, Conn.-based asset manager.

"Periodic dips below par is a temporary phenomenon. Investors should look at total return of their bond funds, which is the yield plus change in prices," McDonald said.

That's easier said than done since over the short term, bond funds can, and do, post negative total returns. In fact, Barclays Aggregate Index (AGG), a benchmark for the broad high-quality bond market, had a rare negative total return in 2013, its only negative year in recent history. Once again, AGG's performance has been disappointing this year, down 2.3% year to date. Compare that with the S&P 500 (.SPX) which is well into a recovery from its first correction in about two years, rising 2.7% year to date.

For Utect, bond investors shouldn't obsess over stock comparisons. He said the best way to invest in bond funds is by focusing on what drives the returns in the long run: cost and tax efficiency.

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