(PUB) Investing 2015

So which is right for you? If you have enough money to buy a diverse basket of bonds and your goals are a steady, known stream of income plus complete preservation of capital, then individual bonds may well be the way to go. On the other hand, if you are looking for more diversification or are investing for total return (both income and the growth of your principal), then a bond fund is likely better suited to meet your goals. Tough Bond Math Let’s turn to the question the Barron’s cover story I mentioned at the top asks: Is it time to ditch your bond fund? My answer is an emphatic no. But I understand why the media is posing the question and why investors are concerned. On its face, the math behind bond returns and rising interest rates isn’t pretty. Remember that when we buy a bond, we are locking in a known level of return, and by taking into account dura- tion, we can have a decent idea of what will happen to our bonds under different changing interest rate scenarios. Let’s take a 10-year U.S. Treasury bond. At the end of June, the yield on the 10-year Treasury was 2.34%, and its duration was 9.0 years. The table below shows what would happen to the price of that 2.34% bond given various moves in interest rates. The risk-reward trade-off, with limited upside and the potential for lots of pain, is out of whack from what we typically want from a supposedly “safe” investment. How Rates Change Returns If the yield on the 10-Year Treasury went to… …its price would rise or fall by… 0.5% 16.6% 1.0% 12.1% 1.5% 7.6% 2.0% 3.1% 2.3%* 0.0% 2.5% -1.4% 3.0% -6.0% 3.5% -10.5% 4.0% -15.0% 5.0% -24.0% 7.0% -42.0% 9.0% -60.1% *Yield as of 6/30/15.

the lack of a contract when you opt for a fund. As I explained last month, when you buy an individual bond, you are typi- cally lending money to a government or corporation, and there is a contract which states how much interest you will receive and when, as well as how long you’ll have to wait before your money is returned to you. Assuming you hold the bond to maturity (the end of the contract) and the borrower does not run into trouble and default, there is not too much more to it. However, when you buy a mutual fund investing in bonds, there is no con- tract. With no guarantee that you will receive a certain level of income, nor that your money will be returned to you in full on a set date, why own a bond fund? Think of all the reasons why you might own a stock fund—such as diver- sification and professional manage- ment. The same applies to bond funds, and then some. Diversifying who you are lending to gives you exposure to bonds with different maturities and yields. Plus, it takes a lot of money for an individual to build an adequately diversified portfo- lio of bonds. Bond funds, even more so than stock funds, bring diversification to investors of all sizes. Professional management is another advantage. Oddly enough, this applies to both indexed and actively managed funds. Total Bond Market holds over 7,500 bonds—good luck trying to rep- licate that on your own. Of course, the other advantage (or potential advan- tage) of an active manager is the ability to separate bond market winners from losers—to find the best values the bond market has to offer. When your poten- tial return is fixed, avoiding the blow- ups matters all that much more. The professionals running your bond fund are also able to negotiate better prices for the bonds they buy. And finally, as other investors add money to their bond funds, the managers can purchase new securities that may provide higher yields than those owned when you first bought the fund. Those higher yields accrue to you as well as your fellow fund shareholders.

es—so $100 in the future won’t be able to buy you as much as $100 could today. Inflation is a cost to all investors. Say you make an investment, and it returns 5% over a period when inflation runs 2%. Your nominal return may have been 5%, but your real return after factoring in inflation is only 3% (real return = nominal return - inflation). If inflation affects all investors, why should bond investors be particularly concerned about it? Let’s go back to the reason bonds are also known as fixed-income invest- ments. Focus on the word “fixed.” When you buy a bond, you are lock- ing in a known or fixed level of return (assuming you hold the bond to matu- rity). But inflation can change over time. If you buy a bond with a 3% yield and inflation is running at 1%, your real return should be 2%. However, what if inflation actually rises to 4%? Now your real return will go negative—from 2% to -1%. On a real, inflation-adjusted basis, you’ve actually lost purchasing power, despite earning a 3% yield. Since one goal of investing is to both maintain and improve our ability to consume in the future, inflation is not to be taken lightly. Bonds vs. Bond Funds To this point I have focused primar- ily on the mechanics of bonds. But there are considerations you need to make when deciding between investing in individual bonds and bond funds. The primary difference is the contract between you, the lender, and the bond issuer, or borrower. Or, I should say,

Inflation Reduces Returns

$0 $100 $200 $300 $400 $500 $600 $700 $800 $900

Long-Term Gov’t Bonds Adjusted for Inflation

6/91

6/93

6/95

6/97

6/99

6/01

6/03

6/05

6/07

6/09

6/11

6/13

6/15

Sources: Morningstar and Ibbotson.

14 • Fund Family Shareholder Association

www.adviseronline.com