How Do Bond Mutual Funds Work?

By Russell Wild from Bond Investing For Dummies, 2nd Edition

When most investors speak of bond funds, they’re talking about mutual funds. And it’s no wonder. According to Morningstar, the total number of distinct mutual funds (ignoring different share classes of certain mutual funds) clocks in at an astounding 7,087. Of those 7,087 funds, 1,739 of them — nearly 25 percent — represent baskets of bonds.

Like all funds, a mutual fund represents a collection of securities. You, as the investor, pay the mutual fund company a yearly fee and sometimes a sales charge (called a load) to buy the fund. In exchange for your money, the mutual fund company offers you an instant portfolio with professional management.

Most mutual funds are open-end funds. This means that the number of shares available is not limited. Within reason, as many people who want to buy into the fund can buy into the fund. As more people buy into the fund, more bonds are purchased. The mutual fund shares then sell at a price that directly reflects the price of all the bonds held by the mutual fund.

The interest you receive from the fund is a pro rata portion of the total interest received by all the bonds in the basket, minus whatever management fees are taken out.

Mutual fund orders can be placed at any time, but they are priced only at the end of the day (4 p.m. on Wall Street), and that’s the price you’re going to get. If you place an order to buy after 4 p.m., the trade is executed at the next day’s closing price.

Most mutual funds are actively managed, which means that the managers try to beat the broad bond market by picking certain issues of bonds or by trying to time the markets. Other mutual funds are passively run, or indexed, which means they are set up to track standard fixed-income indexes. Index funds tend to cost you a lot less in fees than actively managed funds.

Regardless of whether you go with active or passive, choose only those bond mutual funds that have solid track records over several years and are reasonably priced. The average yearly operating expense of a bond mutual fund, per Morningstar, is 1.01 percent. Because total return on bond funds, over time, tends to be less than that of stock funds, the cost ratio is usually a bigger factor.

One of the hottest debates among investors — one that will never end — is whether actively managed investments are any wiser than index fund investments. The vast majority of index investors do better than the vast majority of active investors. Although various studies show various results, none contradicts the basic premise that indexing works, and works very well.

When you look at bond funds in particular, however, things get a bit muddled. On one hand, bond index funds are way cheaper than actively managed bond funds, just as stock index funds are cheaper than actively managed stock funds. But because bond funds tend to yield more modest returns, costs are more important.

A fund made up of bonds that collectively yield 5 percent that costs 1 percent to hold suddenly yields 4 percent; that’s a difference in your return of one-fifth.

But there’s another side to the story, explains Matthew Gelfand, PhD, CFA, CFP, managing director and senior economist with Rockefeller Financial. Despite the cost/yield equation, which Gelfand doesn’t deny for a second is very important, he argues that active management of bonds can make sense. In fact, it makes very good sense, says Gelfand, because bonds are so much more complicated than stocks.

“There are many, many more bonds and kinds of bonds than there are stocks on the market,” says Gelfand. “The analyst coverage is much more sparse. Although more and more trading now is through electronic markets via the web, trading is still mostly over-the-counter, so bid/ask spreads remain wider than in stock markets.

All this makes for a less ‘efficient’ market and allows for good active managers to add real value,” he says. “If you can find a reasonably priced, well-managed active bond fund, it stands a better chance of outperforming a bond index fund.”

There’s certainly nothing wrong with passively managed (index) bond mutual funds or exchange-traded funds. They can, and often do, make excellent investments. Still, handpicking the right actively managed bond fund, if you do so smartly, can juice the returns of your fixed-income portfolio, with limited additional risk.