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Investing for The Wealthy

How Investors Maximize Bond Returns

02/14/2019

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Every investor wants to see an optimal, and ideally maximal, return on her or his investments. And while different investment strategies offer returns on varying timelines, investors often include some form of bonds within their portfolios due to their relatively-predictable natures and return on investment.
While most investors are familiar with individual bonds, some investors may have questions concerning bonds funds and their potential pitfalls. Most investors will also want to learn how they might maximize their bonds returns.
This article aims to clear up some of the questions concerning bond returns, and offer strategies aimed at maximizing yield, particularly as it concerns fixed-income portfolios and assets with predetermined rates of appreciation. Read on to learn more.

What are Bonds and Bond Funds?

Individual bonds are basically loans to corporations. For example, an investor could purchase a $20,000 bond from a large corporation (issuer) such as Ford Motors with a stated interest rate of 6%.

Using this example, the issuer would make coupon payments of $60 at regular intervals (maybe every 6 months) for the duration of the bond, after which the issuer will repay the principal.

Meanwhile, a zero-coupon bond simply repays the principal and the accrued interest. As the name suggests, there are no coupon payments. In this case, the investor could maximize yield by allowing the bond to reach full maturity and self-managing the bond.

The less-understood way to invest in bonds would be to participate in bond funds. These are mutual funds generally run by a manager in which investors buy into a basket of bonds. An on-the-ball manager would then continuously swap bonds into and out of the fund with the goal of maximizing the bonds returns and yield for the investors.

Disadvantages of Bond Fund Products

Bonds in general tend to have lower overall rates of return and take longer periods of time to appreciate, particularly compared to equities or funds such as REITs.

While bonds and bond fund investments are generally safer than investing the same amount of money in equities, the juice may not be worth the squeeze given the time investment and ROI. It takes a lot of juggling, and thus associated costs, to see timely returns from bond funds.

In many situations, bond products may not be a good option for investors with high net-worth. For the reasons explained below, bonds can be particularly disadvantageous to those with more capital to play with:

Cost

To begin, bond funds typically have yields of 3% or less, which could be considered small potatoes by a number of investors. Even with an investment of $100,000, the annual yield could top-out at $3,000, and that’s before management fees are factored in.

While there is some assurance of income and the possibility of maximizing the total bond return, there are certainly other opportunities with potentially-higher yields.

Further shaving down the yield from a bond fund investment is the management fee. A small management fee of 0.65% management fee still eats up a sizable portion of a 2-3% yield.  It’s going to be difficult for any investor trying to maximize yield when he or she is losing 16-33% of the profit to an account manager. In fact, the hypothetical 0.65% management fee actually runs average or slightly-below average in terms of cost. Investors should weigh this before moving forward.

With bond funds, an investor is also paying into an annual expense ratio. In addition to the management fee, investors are also potentially paying administrative and marketing fees.

Morningstar, a prominent mutual fund tracker, determined that the average expense ratio for fixed-income mutual funds is 0.972 percent.

These fees might seem token, but again an investor is weighing an average of almost 1% in costs against a yield of 2-3%. Donating half or more of a given annual yield is not the most effective way to maximize bonds returns.

Before proceeding with bond fund investment, it’s in the best interest of most every investor to get a full schedule of the fees associated with a given bond fund. It may not be to an investor’s benefit if the take-home return is a fraction of a percent.

Lastly, rising interest rates are the antagonist of bond appreciation. This is actually a contemporary problem, as bonds have traditionally been known as a safe place to invest capital and reap rewards, but rising interest rates can have significantly-greater impact on bond funds than individual bonds.

If one or more of these circumstances conspire – and interest rates are currently climbing – it could really cut into an investor’s yield.

While an investor is highly unlikely to lose money with any type of bond investment, an investor could still reap no yield and lose a significant amount of time – which to many investors might be considerably more valuable.

Pre-Existing Bond Portfolio

By buying into a retail or mutual fund, investors are purchasing a portfolio of securities with a pre-existing cost basis. This means that investors who came into the fund later are liable for the full tax responsibility of a given bond fund, but may not reap all the rewards of appreciated securities.

If the aim is to maximize yield, an investor needs to carefully consider the trajectory of both the securities comprising the bond fund, as well as the fund itself, before coming into the investment.

If an investor arrives too late to the party, taxes could end up taking a big bite out of an investor’s potential ROI. Full tax liability and a portion of the profit is not a great way to maximize yield.

However, if a given portfolio is managed by an institution, the investor will not have this issue. In this case, securities are purchased directly upon account inception, and the investor will not be liable for any undue tax responsibility.

Herd Mentality

Like many investments, most mutual funds will at some point decline, at which point other investors will besiege the fund manager with requests for redemptions.

If too many investors attempt to cash-out at the same time, the fund manager will likely be forced to sell from a poor position, as the collective onus will be on the manager to liquidate the fund as fast as possible rather than maximize the bonds returns.

Even if you are a patient investor and willing to wait out the storm, buying into a bond fund means potentially subjecting yourself to this type of herd mentality. The anxiousness of others could potentially cut into the return on your investment.

If you as an investor are planning to use the bond fund as a way to meet your longer-term income needs, this can create a real problem for you. A wave of redemptions from fellow investors could depreciate that value of a bond fund significantly, decreasing your dispersal and affecting your longer-term financial plans.

Manager Bias

Lastly, the bias of individual mangers can become a factor that cuts into an investor’s potential yield.

Active bond funds attempt to time the market by moving in and out of different kinds of bonds and moving up and down the maturity ladder. You as an investor might be confused about what this means, so here is a brief explanation:

A bond fund manager or team of managers scour the fixed income markets for optimal bonds based on the collective goals and objectives of the bond fund investors. Managers will then buy and sell bonds based on market activity.

As noted above, bond fund investors can and will request redemptions or withdrawals from the fund. Managers again will probably have to sell bonds from a poor negotiating position, as they seek immediate return rather than their original goals for return.

For all of these reasons, managers seldom hold bonds within a given fund until they reach full maturity. This is one more way in which bond funds can limit an investor’s yield.

So, for all of the reasons explained above, a bond fund has the potential to cut into an investor’s yield, and in some cases create a situation in which investors are paying out more in management, marketing, and administrative fees than they are netting.

Savvy investors will often do better buying bonds that are specifically designed to maximize yield and help achieve an investor’s cash-flow needs rather than participating in a bond fund.

Buying into a bond fund may not have obvious disadvantages, but a bit of rough math shows that a bond fund gone with a low yield and a heavy fee schedule can produce a net negative. This is far from what an investor wants, even if the net loss is insignificant.

Poor Bond Returns and Income Shortfall

It goes without saying that poor returns can lead to an income shortfall, particularly after an investor retires and perhaps becomes more reliant on bonds returns for as part of a fixed-income plan.  An uncomfortable income situation is the last thing that an investor wants in retirement.

The compound interest from management and marketing fees can also create an income shortfall. A 3% annual fee on a $1 million portfolio over a 20-year period would equate to $1.5 million in total fees. This means that the fees end up being larger than the amount invested.

So, it’s in the best interest of any investor to carefully guard against fees, and to determine prior to investment how much fees can potentially cut into bonds returns.

Attempting to maximize bond returns while reducing fees also has the advantage of making an investor less reliant on equity returns, which are much less predictable. A retired investor won’t have to live and die with every rise and drop of a given equity or index fund if bonds are providing solid returns.

Summary of Bonds vs Bond Funds

By investing into a bond fund, an investor gives up control of which bonds are selected and purchased. Rather than selecting the best bonds for her or her particular financial situation, an investor is forced to revert to the goals of the collective, which may or may not dovetail with their own.

This actually adds a number of unnecessary investment risks:

  • While risk decreases as an individual bond nears maturity, the same can’t be said of bond funds.
  • Individual bonds pay out fixed income, while the income from a bond fund return is uncertain.
  • Individual bonds can be held for full maturity and a predictable yield, but poor timing on the part of a bond fund manager could lead to selling a bond far below it’s ultimate worth.
  • By being in a collective, there is no yield objective specific to a given investor
  • Most of the bonds in the fund will be purchased prior to a newcomer’s investment into the fund. This again may not align with an investor’s personal yield goals.
  • As explained above, selling early creates a situation in which an investor may incur unwanted tax liability.
  • Bonds within an index may offer lower yields, and thus less value, than bonds available outside the index. This is caused by prices being pushed higher once they are added to the index. Due to the low liquidity of bonds, the effect is amplified. In turn, yields are reduced as funds linked to the index are forced to buy.
  • Manager may be unable to recreate a given index, if certain constituent bonds are unavailable for purchase. A portfolio could end up being significantly different than the index it is supposed to track.
  • Events such as bankruptcy or federal investigation related to specific bonds may prevent a fund manager from being able to sell the entire bond position. This too can limit bonds returns, and in some cases cause a net negative.

As you can see, buying into a bond fund potentially creates a number of unnecessary risks that an investor does not incur by purchasing individual bonds.

This is not to say that bond funds cannot be lucrative investments and that bonds returns cannot produce a nice yield. But investors should be appraised of all associated risks before blindly buying into a bond fund.

Closing Tips

The first suggestion to limit unnecessary risks with smart portfolio construction. As explained above, buying into bond funds can be advantageous – particularly for first-time investors – but seasoned investors will likely want to customize their portfolios attempt to maximize bond returns and match their personal yield goals.

Portfolios can be continuously refined, and investors can shed bonds at opportune times. In some cases, it may be worth incurring management fees for the counsel of an experienced bond or fund manager.

But most investors may maximize return by closely monitoring fees and showing patience where needed. Bonds by definition take more time to mature, and not participating in the often-impatient practices of a bond fund is sometimes the better way to optimize yield and bond returns.

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