9

THE THIRD MUTUAL FUND INDUSTRY

WHY INVESTORS SHOULD OWN BOND FUNDS
FIVE RULES FOR BOND FUND SELECTION
FIVE WARNINGS TO BOND FUND INVESTORS

Keynote Address
American Association of Individual Investors
Chicago, Illinois
June 12, 1992

RARELY A WEEK goes by without a major story about equity mutual funds and their portfolio managers surfacing in the news. We could hardly avoid knowing, for example, when Peter Lynch and, more recently, Morris Smith retired, both having done a superb job in managing Magellan Fund. Newspapers and magazines print extensive stories about equity managers who often praise their own prescience, comment on their favorite stocks, and come close to forecasting the stock market (no mean task!).

At least each quarter, Business Week, The Wall Street Journal, and Barron's lionize the managers of the “top performing” equity funds (at least for the previous quarter, but sometimes, in fairness, for a full year or longer). Money, a monthly publication, does so every month. And nearly every financial publication provides an annual performance overview. (Interesting enough, the focus is almost always on the winners, almost never on the losers.)

Since equity funds began it all back in 1924, I suppose that we can call this asset class the first mutual fund industry. Money market funds as the industry's largest component with $575 billion of assets, are doubt-less perceived as the second mutual fund industry. These funds, which arrived on the scene in the mid-1970s, expanded mutual fund horizons to include, not only investors, but savers.

And now, I would argue, there is a third mutual fund industry. It is the bond mutual fund industry. While this industry subset commands relatively little public attention, and its portfolio managers are almost never lionized, and rarely even featured, in the press, the growth of bond funds is one of the most remarkable aspects of the soaring popularity of mutual funds. In fact, today bond fund assets of $440 billion remain in excess of the stock fund total of $430 billion—as they have since 1984—despite the boom in equity prices.

  • Bond fund assets, $3 billion 25 years ago, represented just 7% of the assets of long-term mutual funds. Today they represent 51%.
  • During the 1967–1992 period, bond fund assets have grown at a compound growth rate of 22% annually. Equity fund assets have grown at 10%, less than one-half of the bond fund rate, and indeed, less than what the total return of the stock market would suggest.

So, to borrow a line from Death of a Salesman, “attention must be paid.” And I shall pay that attention to bond funds today. I recognize the risk that I am taking by not discussing equity funds, their performance, and their portfolio managers, but I think the risk is worth taking as I try to provide some stimulating ideas about that third mutual fund industry, composed of bond funds.

It is perhaps paradoxical that the diversity of types of stock funds pales by comparison with that of bond funds. Stock funds largely comprise some combination of three investment sectors (growth, value, and mixed), focusing on one of three general market capitalization levels (large, medium, and small).1 These nine “boxes” compare with 21 for the bond fund arena, with three major maturity levels (short-term, intermediate-term, and long-term) and seven distinctly different investment sectors (U.S. Government, Investment-Grade Corporate, Medium-Grade Corporate, “Junk” Corporate, Investment-Grade Municipal, High-Yield Municipal, and Global). (Table 9.1) While not all of these 21 neat “pigeon holes” are filled, we have “forced” some other types of funds (such as GNMA and Adjustable Rate Mortgage funds) to conform to the table in the exhibit. In any event, 21 is not a bad estimate for the variety of bond funds available.

In my remarks, I shall discuss three aspects of this subject: first, why own bond funds at all; second, five general rules for investors to follow in their decision as to what types of bond funds they should consider; and third, five strong warnings about funds with specific characteristics that should be avoided or, at the very least, viewed with great skepticism. Let's turn first to the question of the value of bonds as an investment opportunity.

Why Own Bond Funds?

First, why indeed should investors own bonds at all? Is not the historical record clear that the long-term (since 1926) nominal return on corporate bonds is but +5.4% per year, compared with an average return of +10.4% for stocks? (The real returns of each, adjusted for inflation, are of course some 3% lower.) I believe that we should disregard this historical evidence—I call it “hysterical” evidence—since the current level of long-term interest rates suggests, indeed it virtually guarantees, that future bond returns will be far higher than in the past. In fact, the average initial interest rate on such bonds in the 1926–1981 period is estimated at 4.9%, compared to a rate of 8.8%—nearly twice that level—today. So, I believe that the odds suggest that, during the coming decade, bonds will give a much more favorable account of themselves relative to stocks. Assuming today's price-earnings ratio of about 19 times remains at that level during the coming decade, stocks may provide returns in the +9.2% range—2.9% current dividend yield plus 6.3% estimated earnings growth.

Even if the returns on long-term bonds fall somewhat short of stock returns (a situation that is by no means guaranteed), they provide investors with a useful asset class—fixed-income securities—with which to diversify their investment portfolios. At the minimum, bonds will moderate the price volatility of an investment portfolio; at the maximum, they should provide a haven against a severe deterioration in the ever-volatile stock market—always a hazard to the investor's capital.

TABLE 9.1 The Fixed Income Fund Industry, April 1992 ($ Billions)

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At the same time, short-term bonds presently offer a high yield premium relative to cash reserves, in exchange for only a modest increase in principal risk. With today's steep yield curve, a three-year Treasury bond offers a yield of 5.9%, fully 2.1% (210 “basis points”) above the 3.8% yield on Treasury bills. (Figure 9.1) Put another way, even if interest rates rise sharply, a bond with a constant three-year maturity could lose 2% of its principal value every year for three years, and still earn the same net total return. (The chance of a symmetrical decline in rates is probably 50–50; under that circumstance, the notes would deliver an annual return of +8.0%.)

It is but one small step from bonds to bond funds. Their portfolio management and remarkable range of shareholder conveniences are of the same high intrinsic value as with stock funds. They maintain a “constant maturity,” rather than one which gradually shortens as the day of maturity approaches. And, very importantly, their broad diversification can—without extra cost to the investor—mitigate the substantial principal risk that can easily “come home to roost” to haunt an investor who owns only one or a handful of bonds that are downgraded or default. Bond funds—at least when “the price is right”—are essential components of the investment program of the prudent investor.

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FIGURE 9.1 Treasury Yield Curve, June 1992.

So, the case for bond funds is strong, both for equity investors seeking to reduce overall portfolio risk and for money market investors seeking to enhance income. Let's now discuss five general rules for the selection of bond funds.

Five General Rules for Bond Fund Selection

GENERAL RULE 1 Recognize that bonds carry “interest rate risk.” But consider not only risk to principal but also risk to income. Principal risk increases with length of maturity. That is, rising rates means lower prices, and vice versa. Income risk, however, decreases with length of maturity. Simply put, a 90-day Treasury bill has no principal risk, but an enormous income risk. (In fact, its annualized yield has fallen from 9.3% to 3.8% during the past three years!). An 8% 30-year Treasury bond, on the other hand, will crank out $8 per year for each $100 initially invested for three decades, but interim fluctuations in principal value of plus or minus 20% should be expected. So, the investor's task is to consider short-term bonds and long-term bonds and to balance out principal risk against income risk.

GENERAL RULE 2 Consider the impact of income yield and principal change on total return, in the light of the length of time that you expect to own the investment. For the very short-term investor, the principal risk embodied in rising interest rates will overwhelm the lower income return; for the long-term investor, potential principal losses will be reduced by the higher interest rates usually available on longer-term maturities. (Currently, the “spread” between the yield of 8.0% on long-term Treasury bonds and the yield of 3.8% on Treasury bills is 4.2%—420 basis points—dwarfing the average spread of 120 basis points during the past 25 years.)

For example, a 25-year Treasury bond would provide a one-year total return of −10% if interest rates rose by 200 basis points and a return of +31% on a commensurate rate decline; however, after five years the range of respective rates of return narrows to +6% and +11%. After eleven years the gap is in fact eliminated, and the interest rate rise then turns to the bondholder's advantage. At maturity, the average rate of return would be +9.2% in a rising rate environment and +7.0% in a declining rate environment.

The perhaps obvious long-term value to investors of higher rates versus lower rates is dramatic. A $10,000 investment in a 25-year Treasury bond would have a terminal value (including interest) of just $9,000 one year after the 2% rate increase, and a value of $13,000 following the 2% rate decline. Then, the values begin to converge, crossing in the eleventh year. After 25 years, when the bond ultimately matures, the $10,000 investment is worth nearly $94,000 in the rising rate environment and just $55,000 in the declining rate environment—a 60% difference in value! This reversal is, in a sense, a reaffirmation of the centuries-old aphorism that “it's an ill wind (indeed) that blows no good.” The reason is that higher yields, while they have a negative short-term impact on prices, have a positive long-term impact on returns since interest payments are reinvested at higher (i.e., more attractive) rates.

GENERAL RULE 3 Consider—very carefully—investment quality. Interest rate risk (remember, the longer the maturity, the greater the portfolio's near-term sensitivity to interest rate changes) is but one of two major risks assumed by the bond fund investor. The other is quality risk—the risk that a bond will be unable to meet its specified interest coupon and, at maturity, to repay its principal. In terms of quality, U.S. Treasuries are the safest of bonds, junk bonds the riskiest. The recent “quality curve” showed the yield for a 30-year U.S. Treasury bond at 8.0%, an Aa bond at 8.7%, a Baa bond at 9.4%, a Ba at 9.9%, and a B (junk) bond at 11.9%. (Table 9.2) Thus, the market is saying, for example, that Baa bonds (the lowest “investment quality” grade by the definition of Moody's Investor Services) must provide the investor with a 140-basis-point premium over U.S. Treasuries in order to compensate for the extra risk.

TABLE 9.2 Yield by Quality Rating

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GENERAL RULE 4 Consider at least two other kinds of risk. (Yes, there are still other risks in fixed-income investing.) One is prepayment risk—most typically the risk that mortgages held by GNMA “pass through” certificates will be prepaid. This process, which invariably accelerates when rates decline, can appreciably shorten what would otherwise appear to be a steady long-term string of payments. (What is more, when rates rise, prepayments slow, also an unfavorable outcome.) The second is currency risk, which exists in foreign bonds. Specifically, the value of foreign bonds fluctuates inversely with the value of the dollar in international currency markets—a strong dollar means lower prices for foreign bonds, and vice versa.

GENERAL RULE 5 Consider the taxability of interest payments. Interest payments on municipal bonds are generally free from Federal income tax, and (important in states with high income tax rates) bonds of that state are usually free of state taxes too. As a result—since financial markets are highly efficient—municipal bonds provide lower yields than taxable bonds. Investors, then, must calculate which alternative produces the most after-tax income. For example, a 10-year Aa corporate bond presently yields 8.1%, compared with 6.0% for a comparably rated municipal bond. Since the latter rate is 26% below the former, the municipal bond represents approximately “fair value” only to investors paying marginal combined state and Federal tax rates in excess of 26%.

With these five general rules in mind, let's now turn to my five warnings regarding the selection of specific types of bond funds.

Five Warnings about Bond Fund Selection

WARNING 1 Never, never, never invest in a bond fund without knowing its expense ratio. While some stock funds, some of the time, may provide premium performance despite prodigious costs, most bond funds, most of the time, will fail to do so. Specific types of bond funds—for example, those investing in long-term U.S. Treasury bonds—tend to be homogeneous in nature, and differ most importantly only in their expense ratios (operating expenses as a percentage of net assets). Such expenses represent the amount taken by the fund's management from the gross interest income earned by the fund before the distribution of net income to the fund's shareholders.

In fact, the cost differences are staggering. (Table 9.3) General government bond funds have annual expense ratios ranging from 2.40% for the highest five funds to 0.36% for the lowest five. Their average expense ratio is 1.14%. For investment-grade corporate bond funds, expense ratios are 1.69% for the highest, 0.30% for the lowest, and 0.89% for the average. For municipal bond funds, the expense ratio range is 2.31%(!), 0.25%, and 0.87%, respectively. It is virtually inevitable that, when maturity and quality are held constant, higher costs will result in lower returns and vice versa.

Within the major bond fund categories, most, if not all, funds exhibit relatively comparable quality standards and little significant difference in maturity. U.S. Treasury bonds, for example, all have identical credit ratings, and are segmented into fund portfolios that are fairly clearly identified as long term, intermediate term, and short term. Insured municipal bonds are all rated Aaa. And so on.

So, powerful odds suggest that a lower cost bond fund will provide a higher return than its higher-cost cousin. With the wide variety of funds available in each category, it does not make much sense to own one with annual expenses of 1% or 2% or more, which, simply put, would reduce an 8% yield to 7% or 6%. And, even expenses much over 50 basis points seem a bit rich. In any event, the investor should, without fail, be aware of what portion of his income is consumed by fund expenses.

(I should add that it has become increasingly difficult to get meaningful fund expenses information. Many new funds begin with “teaser” yields that are substantially enhanced by waiving expenses. They then “guarantee” midrange expenses for several years, before the expense ratio moves to a permanently higher level. Be sure to get all three expense ratios, and a copy of the “guarantee.” Lots of luck!)

WARNING 2 Do not take quality for granted. I have never seen a corporate bond fund advertisement that addressed the quality issue, and, so far as I can tell, most bond funds do not report quality standards in their prospectuses, nor do they provide the quality ratings of their current portfolios in their reports to shareholders. Yet many so called investment-grade funds are reaching out for yield, in part doubtless to offset their higher expenses. The differences in quality are often dramatic. Consider the selected examples in Table 9.4.

TABLE 9.3 Bond Fund Cost Factors (Expense Ratios)

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TABLE 9.4 How Bond Funds Differ—Some Extreme Examples

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  • Two short-term corporate bond funds in Table 9.4 have portfolios including, respectively, 13% and 62% of bonds rated Baa or below. Yet the lower quality portfolio—given its high expenses—provides only a marginally higher yield (8.2% vs. 7.9%).
  • Two long-term municipal bond funds in Table 9.4 hold portfolios rated, respectively, 98% and 50% A or above. Given its astronomical expense ratio (even while ignoring its sales charge), the lower-quality fund provided a net yield of 5.8% vs. 7.1% for the high-quality fund.
  • The portfolio of one California state municipal bond fund Table 9.4 is rated 40% Baa and below; another comprises 100% Aaa insured municipal bonds (which may be especially important in an earthquake-prone state!). But the insured fund provides a net yield of 6.2%, compared with 5.4% (ignoring the hefty sales charge) for the uninsured fund. (Just imagine an investor being paid 0.8% for buying an insurance policy!)

I believe that a lower quality bond portfolio with a commensurately higher expense ratio than other funds with comparable maturities should never be purchased by an investor. That is to say, if one hypothetical portfolio has a gross yield 1% or higher than another, and an expense ratio 1% higher, both funds will deliver the same net yield. A gross yield premium of 1% happens to be the spread between a 10-year Treasury bond (7.6%) and a Baa industrial bond (8.6%), as shown previously in Table 9.2. Thus, the higher expense ratio means that you are, in substance, paying the price for a Treasury bond, but receiving in return the value of a medium-grade industrial bond for your money. It is not a sensible trade-off.

WARNING 3 Beware of the impact of sales charges. Such loads are incurred by investors in 369 of the 598 bond funds listed in Table 9.3. Front-end loads immediately reduce the principal value of your investment, resulting in a significant reduction in yield. For example, a net yield of 6% in a no-load fund would be reduced—all else held equal—to 5.7% in a fund with a 5% sales commission. And, even this reduced yield implies that the fund's shares are held to infinity. Spreading the load over five years reduces the 5.7% yield to 5%; and, obviously, if the shares are held but one year, the yield drops to a mere 1%. The sales charge, then, is a factor that is particularly important in choosing between fixed-income funds with comparable quality, maturity, and expense ratios. (Some bond funds—unbelievably!—also assess a sales charge when a shareholder reinvests his dividends. This practice reduces yield by another 0.3%. Avoid it like the plague!)

Front-end sales charges are often hidden by the use of “contingent deferred sales charges.” If you exit from the fund in the first year, there is typically a 5% load penalty, which usually drops to 0% in the sixth year. In such funds, you normally pay another 1% each year in expenses, often during your entire holding period. However hidden the charge, it has the same impact as a front-end sales load during the first five years, and an impact that is truly baneful in each subsequent year, during which the 1% charge is paid over and over again.

WARNING 4 Do not take yield calculations at face value. There are simply too many ways to calculate yields, to say nothing of enhancing them, to facilitate comparative analysis. For example, bond fund yields may be calculated on a “current yield” basis (income as a percentage of market value) or on a “yield to maturity” basis (amortizing premiums and discounts over the life of the bonds). You have a right to know both of these yields; if you can't get them, take your money elsewhere.

To clarify this point, if, for example, a bond fund owns a portfolio of “premium” bonds selling, on average, at a price of $105 and with a five-year maturity, the current yield (assuming a 6% coupon) is 5.7%; the yield to maturity, however, is 4.9%, since principal will decline by 1% annually. It is generally municipal bond funds that have invested heavily in “high coupon” bonds, issued for the most part during the high interest rate environment of the early to mid-1980s and now losing their (initial 10 years of) call protection. With coupons well in excess of the current market level, such bonds are highly likely to be “called back” by their issuers during the next few years. They will be replaced inevitably with bonds providing much lower yields. As a result, dividends on municipal bond funds that follow a “high coupon” strategy are riding for a fall.

Perhaps nowhere is the complexity of yield calculations more evident than in mortgage obligations. Calculating a yield to maturity for GNMA securities, for example, requires some assumptions about mortgage prepayments under existing market conditions. But both current yield and yield to maturity calculations ignore possible prepayments. It is clear that GNMA funds which own obligations with high coupons run a far greater risk of acceleration in prepayments than those funds emphasizing low coupon obligations (which reduce such prepayment risk). Complex as it may sound, the wise GNMA investor should know this data. (Average coupon data for GNMA funds is provided in Morningstar; any prepayment assumptions are available only from the fund sponsor.) The issues are even more complex when collateralized mortgage obligations (CMOs) are held in a bond fund's portfolio, but the information should nonetheless be obtained from the fund sponsor.

Under circumstances such as these, there is a clear tendency for fixed-income funds of all types to maximize apparent yields by owning premium bonds with high coupons and by making heavy commitments to mortgage obligations. These practices cry out for full disclosure.

WARNING 5 Avoid fixed-income “gimmick” funds. A few years ago, an apparent investment miracle took place with the creation of “Government Plus” bond funds, which were to provide, miraculously enough, higher yields than government bonds, even after hefty fund expenses. The trick was to add to the interest income substantial premium income by selling options on the bonds. This would be a marvelous strategy indeed if the managers could accurately forecast the rises and falls of interest rates. Apparently, however, none did. So the Government-Plus fund held on to the bonds when they dropped in price and had them called away when they rose. This highly predictable ratchet effect had the obvious result: Principal was gradually eroded, and income gradually deteriorated. The theory—predictably—failed in practice. It was a “black eye” for the mutual fund industry—even though it seemed to escape much public notice.

Are other gimmicks likely to lead to other black eyes? I believe that the answer is “yes.” The most likely present candidate, in my view, is the “Prime Rate” fund—investing in bank loan participants of dubious quality and liquidity. These funds were to have periodic “tender offers,” allowing investors to redeem. At least one such fund, however, has suspended its tender offer, but, to provide shareholder liquidity, listed its stock on the New York Stock Exchange. The shares, ostensibly still valued at the initial $10.00 per share, recently traded at $8⅞. For shareholders in these funds, presented as money market fund substitutes, it is a sorry situation.

It is too soon to say whether or not other “hot new products” from this most creative of all industries will prove to be gimmicks. Presently, there is a boom afoot in global short-term bond funds and adjustable-rate mortgage funds, both of which have very limited histories over which to make a fair evaluation. Moreover, both own highly complex investments and engage in equally complex strategies. Certainly they carry at least the principal and income risks of short-term corporate bond funds. So, the yields of all three types—two novel, one fully tested—should be compared with one another, and not with the yields of money market funds, which carry far less principal risk.

Conclusion

Let me summarize and conclude. First, bond funds today, it seems to me, represent an attractive investment opportunity: long-term bond funds by providing potentially competitive returns and substantially lower risks relative to stock funds; and short-term bond funds by providing higher and more durable income while assuming measurably higher risks than money market funds, but not much higher.

Second, the choice of bond fund sectors will vary substantially from one investor to another, depending on that person's income requirements, tolerance for interest rate risk, willingness to assume quality risk, and expected holding period.

Third, once investors decide on the types of bond funds that fit their needs, they should be careful and thorough in their individual fund selections. They should ignore advertisements that point to high yields (“the highest-yielding short-term bond fund!”) if they do not disclose, in the same size type, the quality, maturity, coupon structure, and other relevant portfolio characteristics of the fund. And, investors are also entitled to the same forthright and prominent disclosure of the fund's expense ratio.

Finally, I believe that most investors will conclude that bond fund returns can be predictably enhanced by only two factors—one, higher risk, generally measured by longer maturities and/or lower investment quality; and two, lower operating expenses. To state what I believe is obvious, the latter is the more sensible and more productive strategy for enhancing yield. So, as improved disclosure is demanded by investors and regulators, as perceptions about yield are replaced by the hard realities I have discussed today, and as expenses are driven to more realistic levels that are fairer to the investor, bond mutual funds should continue to provide excellent opportunities, and “the third mutual fund industry” should continue to grow apace.

  1. These are the basis differentiations utilized in the new Morningstar equity mutual fund system. International and industry specialized would be important subcategories.

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