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| High costs make these a bad bet.
And the industry has a history of dishonesty in advertising
these products |
Bond funds have the same legal structure as Unit
Trusts or OEICS. But they contain bonds instead of equities.
What's wrong with them?
To quote the Financial Times: "There are concerns that investors
are not always aware that their income and capital are at risk when
they put money in a corporate bond fund or of the extent to which
that risk varies depending on the type of bond the fund invests
in".
We have two fundamental objections to bond funds:
- Bond funds are complicated. This would not
matter if the industry could be trusted to sell them properly,
but they have, in the past, taken advantage of a lax disclosure
regime to persistently misrepresent the attributes of funds. More
on this below.
- The costs are too high.
What's in a yield?
You need to understand all the different yields.
Unless a prospectus describes a yield precisely you
are potentially being mislead. Here are some possibilities:
- Fund groups are fond of quoting a 'current
annual yield'. This has little meaning on its own: the 'yield
to redemption' means more. It's quite easy to bump up the current
annual yield without changing the economic position of the fund
by investing in bonds with a coupon higher than current market
yields (which will therefore cause the bonds to be priced above
par). The loss to redemption will offset the high current yield
to bring the yield to redemption to its market value.
- Any yield is good or bad depending on the
average duration of the fund - in other words the fund's position
on the yield
curve.
- Any yield number is irrelevant unless it's
related to risk. The yield on a bond is a reflection
of its default risk. The yield on a Walmart bond will be low.
The yields on the bonds of Transafrican Mining PLC or Upper Ruritania
will be high. The difference between the yields on Walmart and
Transafrican could easily be 5%.
- You might think that a fund's investment
objectives or principles would give some guidance on risk. Here's
a typical one: "The fund invests in a
range of investment grade and high yield corporate bonds".
In other words, all bonds.
- Charges!
Charges!
Do not think that the stated yield is necessarily the income available
to the investor. There are still charges to come. These might include:
- an initial charge (0-5%),
- annual management fee
(1.25/1.5% per annum for a general bond fund, more for a specialist
fund),
- other administrative
expenses (rarely mentioned in prospectuses, might be about 0.25%),
- dealing costs (never mentioned
in prospectuses).
- defaults
Fees can be charged to capital
This is a smoke and mirrors accounting affair that allows promoters
to say that fees will not reduce your income. Well, maybe, but in
that case they will reduce your capital.
But are they a good buy?
Look at it this way. The risk premium of a good
quality corporate bond over a government bond ('gilts') may be 0.5/1%.
So what's the point of taking extra risks to earn 0.5/1% extra return
and then paying someone else 1.5/2.5%? You
end up with less than you started! And more risk! You might as well
buy gilts yourself and keep the money. Risk
Premiums
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