Best Way To Buy Bonds

Investors with less than several million should use mutual funds as a vehicle to acquire a position in the asset class of bonds instead of buying individual bonds. I recently tested the waters by selling a 30 year Treasury for my own account and was charged a 0.25 point spread between bid and ask. However the zero coupon bond was trading at 46 points so that means the quarter point spread was really 100/46 times 0.25 or 0.54% cost to trade, plus a commission of $95, for a total cost of about 0.75%, even though Treasuries are very liquid and much easier to trade than other bonds.

Basically the fixed income market is stuck in the high brokerage cost era before the 1990’s when stockbrokers started offering cheap online trading for stocks and mutual funds, so the best way to trade bonds is to buy the asset class of bonds by using a mutual fund. Avoid Closed-End bond funds because they have a problem with a premium or discount over net Asset Value (NAV) plus high annual fees. By using no-load open end mutual funds you avoid the bid-ask spread that is significant in the bond market. Even mutual funds are trying to avoid getting hurt by the bid-ask spread by trading bonds less and instead using derivatives to implement a change in investment policy. If a bond fund manager seeks to reduce the portfolio’s duration he might simply buy a derivatives contract instead of selling and buying bonds. He would still maintain a position in bonds, so the derivatives would merely be an overlay on top of the bonds owned by the fund.

Bond mutual funds issue data about their dividend yield from continuing operations and their annual capital distribution which is likely to be a temporary, unreliable type of income. Unfortunately prominent data services fail to report this properly. They lump these two items together and call it a “yield”. But yield paid by a mutual fund is the recurring dividend and not the “distribution” of capital gains that is paid out annually in December or November.

Today people are desperate for yield so they simply look at the total payout and treat that as yield, but that figure is contaminated with temporary one-time capital gains realized by the mutual fund company and “distributed” to investors. Also interest rates have gone down so much that a one year average of dividends is misleading; instead look at the most recent three months but exclude any sudden increase in yield unless the fund company can clearly explain why that happened. The best source is to read the mutual fund’s website for all documents published in recent months and search for “SEC 30 day yield” This figure is adjusted for artificially high yields caused by buying high yielding bonds at a premium price and does not include the capital gains distribution. Surprise, surprise, most mutual fund companies make it hard to find the data but if you really try hard you can find it disclosed on their website. I would judge a fund by how honest it is to fully disclose key data in a clear, obvious way instead of obfuscating in hopes a lazy reader will only read the total annual payout.

If two fund companies are compared to each other and one has had a higher total return in the past that could be because the higher performing fund made a one-time windfall profit by holding long term bonds. If those bonds stop appreciating or have now been sold then the fund company will make less income in the future. So a fund company with a five year bond may have made a bigger capital gain than a fund with a one year bond because prices went up. This is unsustainable. Instead investors should look at the SEC 30 day yield for a clue as to how the fund may perform in the future. That needs to be adjusted for credit quality. This means that a junk bond with high yields could go down in value if a recession occurs. Also, a good yield earned in the past does not protect against the risk of loss of principal should interest rates go up because then bond prices will go down. Of course getting a good yield can help the total return “less worse” if the bond market crashes, but you don’t want to be in bonds if they go down in value.

The bizarre conundrum of bond investing is that during the inflationary 1970’s the best performing asset class was short term high credit quality bonds, even though bonds get hurt by inflation. The stereotype of bonds is that rising inflation leads to rising interest rates which definitely hurts long term bonds. The stereotype of stocks is that they are a hedge against inflation but in the 1970’s they didn’t protect investors from inflation. But short term investment grade bonds that paid a 14% coupon were the best investment during the horrible 1970’s.

About the author

Don Martin, CFP®

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