Open-end bond mutual funds may represent the very worst way for investors to own fixed income. Why is that?
With fixed rate CDs and Bonds:
- If rates decline, bond prices go up.
- When interest rates increase, bond values decline.
The owners of bond mutual fund shares lucky enough to buy when rates were high might have thought they would keep getting the attractive average coupon rate in effect when they bought their shares.
After rates dropped, other investors saw the high income level and flooded that fund with new money. The managers of that open-ended fund get paid based strictly on the amount of money they invest. They are always happy to take in new net inflows.
Newly issued shares dilute out the old coupon rate because the added money must be put to work in lower interest bonds. The original holders end up with a blended rate that is worse than they started with, even though they didn’t buy or sell any shares themselves.
The bond fund’s net asset value (NAV) doesn’t go up in the same way an individual bond would have based on the decline in coupon interest rates.
The converse is also true. If interest rates are rising the value of exiting bonds falls. Net redemptions occur as the rats flee the sinking ship. The remaining holders of open-ended bond funds will see their NAV fall. Intrepid investors who stay the course end up taking all the losses incurred because of higher coupons.
Fund management can’t take advantage of the new higher rates as they are forced to sell existing paper to meet redemption requests.
In good environments bond fund investors don’t benefit fully. In poor rate climates they get doubly punished.
What can you do to avoid these problems? If you insist on owning fixed-income vehicles…
1) Buy individual CD or bonds rather than open-end bond mutual funds.
2) Buy closed-end bond funds that are selling for discounts to NAV. They are typically not subject to the problems that money flow creates.