The stock market isn’t for everybody and some investors like to have at least a portion of their assets in bonds. They like the income and the fact that bonds don’t usually fluctuate the same way stocks can. I get it.
If you are in that camp you still have to be rather picky about which bond fund you buy. If not you could end up paying high fees unnecessarily and/or take on a lot more risk than you thought you were taking. Here are a few of the safeguards I suggest you put in place before buying any bond fund:
1. Commissions and Fees
No matter what anyone tells you, every fund and ETF charges ongoing management fees. On top of that, some bond funds charge you a commission when you buy it or a commission if you don’t hold on to it for 3 to 5 years. This is often the case with funds that are sold by commission brokers because it’s the only way those brokers get paid.
Avoid commission bond funds like the plague and look for funds with lower ongoing management fees as a general rule.
Having said that, don’t get fanatic about fees. When you compare different bond funds the total return is shown net of all management fees so if a fund has a great manager he or she can make up for higher costs with better performance. At the end of day, you are looking for safety and income and if it costs a little more to get a great manager, fees shouldn’t stop you. Just remember that past performance is no guarantee of future results friend.
2. Income Vs Return
Many investors confuse income with return. It’s an easy mistake to make but its super costly. Let me illustrate by way of example. A few years ago a friend of mine named Robert bought a bond fund that paid a hefty 12% interest rate. The only problem was that the bonds were very risky (that’s why the rate was so high) and they declined in value big time.
Yes Robert earned $12,000 on his initial $100,000 investment. But when things turned sour, his bond fund lost 20% of its value. That melted his $100,000 down to $80,000 within 12 months.
At the end of the day, Robert had his $80,000 plus the $12,000 interest, or $92,000. That’s a loss of 8,000 clams and a very painful experience. Always consider total return and not just income when buying bond funds.
Obviously risk is a huge consideration before making any investment and bond funds are no exception. There are a variety of risks to buying bond funds including the kinds of bonds that are bought and the length of maturity. And there are other risk factors as well.
In order to make sure you are aware of all the risks you really have to read the fund prospectus. I know that sounds like a fate worse than death but it really isn’t that bad. You don’t have to read the entire document. In fact if you follow the advice I provide in the link above, you can master the prospectus and Statement of Information in less than 20 minutes.
The reality is that if you want to get a bead on the risks, costs and performance, you really have to consult the prospectus. There is no other place where you’ll find this information.
I’m not a big fan of bond funds and I think people often buy them because they don’t really understand how to use equity funds to provide income. I generally think that equity funds can offer better returns, income and an potential inflation hedge that bond funds can’t. But that doesn’t mean that bond funds are a bad investment. I think they can make a lot of sense for the right person (in moderation).
Do you buy bond funds? How do you decide which to add to your portfolio?