Bond Mutual Funds - The Worst Investment Vehicle Ever?

The investment public has been throwing more money into bonds and bond mutual funds than ever before in history. Fear of our poor economy further depressing stock prices has prompted this move out of equities and into fixed income. Rather than focusing on the merits (or lack thereof) of locking in generational low coupon rates let’s examine the nuts and bolts structure of open-end mutual funds – the type that has attracted most of the new inflows.

PIMCO, the world’s largest bond manager, was just on CNBC touting bonds as “the place to be”. No conflict of interest there, right?

For ease of understanding I’m going to use exaggerated interest rate movements in this explanation to illustrate the problems with the typical bond fund. Note: This does not apply to closed-end bond funds which have a fixed amount of money to manage and trade on a supply and demand basis like stocks do.

Our theoretical example;

Mutual fund holders of ABC are happy with their 10% current yield and feel sure that they will benefit if interest rates decline because “bond values go up when interest rates move down”.

They were correct in their prediction that long –term rates would drop as by June 30^th the new 20-year Treasury issue was at 5%. You’d think that the original investors would be doing great in that environment.

What probably happened, though, was something like this…

As rates fell and newly issued bonds were paying less and less investors could see the 10% current yield on ABC fund listed in their newspapers or on-line screening tools. Rather than buy new 5% coupon bonds they flooded ABC fund with $200,000,000 of new money to get their share of those old 10% yielders. On June 30 the ABC fund profile might have looked like this…

Why did the yield drop to 6.6667%? When the new $200,000,000 of shares were bought the yield on 20-year paper was down to 5%. ABC management needed to put the new money to work and bought bonds at the lower coupon rate. This diluted the returns of all the smarter investor who had the prescience to buy when rates were high.

Those initial ABC fund holders saw their income drop by one third as the new money ‘stole’ their old 10% coupons by flooding ABC with huge new purchases of shares. Open-end funds have no limits on how much new money they will take in and thus no protection for old shareholders against dilution from new ones. In fact, PIMCO and others bond managers welcome new money as they take their fees on a percentage of assets under management – not on fund performance.

If you had simply bought 20-year 10% coupon Treasury bonds directly on January 1^st you’d still have been receiving that rate until maturity (or the call date) and any appreciation would be there for the taking should you choose to sell earlier.

What would have happened if interest rates had gone up instead of down?

If newly issued 20-year Treasuries were paying 15% coupons on June 30^th there would have been net outflows from ABC bond fund as smart investors saw the chance to ‘abandon a sinking ship’ by redeeming their shares and then investing in newly formed bond funds or individual bonds that were paying 50% more than the average rate on ABC bond fund shares. 

ABC fund managers would be forced to sell some of their old 10% coupon bonds at losses to make redemptions to those astute shareholders who cashed out. People who failed to react and held on to ABC would be saddled with those realized losses to NAV and would still be receiving below market interest rates on their ABC fund shares.

Regardless of how attractive the new 15% bonds might have looked, the ABC managers would have been forced to sell old paper and would be unable to buy new higher-yielding bonds because of the net outflows from redemptions.

Conclusion: Open-end bond funds are a lose/lose proposition for individual investors. If rates go down you don’t fully benefit due to dilution. If rates go up you are left holding the bag (and the losses) from those investors who abandon ship.

Not only do you face these horrible headwinds as an open-end bond fund investor you also must contend with expense ratios that severely eat into any currently available fixed income returns.

PIMCO Funds Fee Structure and Returns

Morningstar ratings indicate that the expense ratio for mutual funds at PIMCO range from below average for their international stock funds (1.14%) to average (1.02%) for their taxable bond fund.