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This post is part of a larger mini-series called The Ultimate Guide to Understanding Bonds. You can read the rest of it over here.
Rather than buy individual bonds, most of us will be looking to park our money in a fund where a money manager goes around and purchases a bunch of different bonds on our behalf. There are two types of funds you can purchase. One is called an open-ended fund, which means that they are constantly taking new capital contributions. When you invest, they go and expand the pie with more bonds. We mostly know them by the name “mutual fund” as mutual funds are one kind of open-ended fund. The other is called a closed-end fund (CEF). These funds raise a set amount of capital then deploy that over the years. New buyers are purchasing existing shares from other holders as the fund does not issue new shares along the way. Unlike an open-ended fund, the dollars deployed in a CEF are unchanged – they were raised long ago. While there is different terminology and a few differences in consideration, the majority of your concerns are the same for both.
These are the 8 things it is important to evaluate before purchasing a mutual fund for bonds, ordered roughly by their importance.
8 Key Mutual Fund Factors – Bonds
Dividend Yield: This is an obvious one, but you will want to look at what the fund’s monthly dividend payout is as a percentage of the price you’d be paying. The higher the better.
Tax Exposure: Figure out what types of bonds this fund purchases (i.e. corporate vs municipal/government bonds) and what tax exposure will do to your net returns. I would take a bond fund yielding 5% which is tax exempt over a bond fund which is yielding 5% and is not tax exempt. Depending on your tax bracket, this may be a 20% swing in returns for you. Generally you will find tax exempt funds investing in government bonds (fed, state, and local level).
Call Exposure: What percentage of bonds are callable in 2017, 2018, etc.? This generally matters more in a declining interest rate environment because borrowers do not want to call their sweetheart deals and have to issue new bonds at a higher interest rate. While the Fed has signaled increasing rates in the near term, just note that for many companies, their first call window in years may still happen in 2017 or 2018 and that the going rate will be much lower than when they locked something in years ago, so expect to still see calls exercised over the next couple years even if you expect interest rates to go up.
Maturity Breakdown: What is the concentration of bonds maturing in 1 yr, 5 yrs, and 10+yrs? The higher the concentration in longer-term bonds, the more insulated your fund will be from changes in the interest rate. That can be a good or bad thing, depending on which way interest rates are moving. If interest rates are declining, for example, you are hoping for long maturities because otherwise your fund will have all of its juicy high interest rate bonds expiring soon and will have to go back to the market to buy new ones which are now offering comparatively lower rates. If it is an increasing interest rate environment, the opposite is true.
Credit Quality: Look at the concentration of AAA vs B rated bonds in the fund. You will see higher dividend yields from funds that are active in lower quality bonds. In the past, most of my investment has been in municipal bond funds where the bonds are generally higher quality as they are guaranteed by government entities. Thus, I like funds where 85-90% of bonds are concentrated in AAA (highest rating), AA, and A. Other issuers such as corporations don’t tend to have the same make-up of AAA quality but in return for the extra risk they tend to pay more. Regardless of which type you are targeting, compare your final shortlist on credit quality. You will see sometimes see funds with the same dividend yield where one has vastly better credit quality. I’ll take that higher quality one every time as that means there’s less chance of a default and a hit to future dividend yield.
Leverage: You might notice in a fund screener that certain funds are yielding much more than other funds. That may be because they use leverage. By using the bonds they own as collateral, they can take out loans at low interest rates and deploy that into more bonds on your behalf. Read the rest of the Ultimate Guide To Understanding Bonds for more information on the exposure you take here. This is neither good nor bad, it simply depends on your view of the risk vs reward. Typically you will not want a fund more than 30-35% leveraged, though banks really won’t allow them to get much higher than that anyway. Just make sure you double check to make sure you are buying a fund that aligns with your views on leverage.
Assets Under Management (AUM): You want to make sure the AUM of the funds you are considering meet a minimum threshold. This allows them to diversify their holdings and suggests they will have enough infrastructure for good research and stewardship and won’t go away overnight. I generally like to pick funds that are greater than $500 million. You shouldn’t have trouble finding funds that meet this limit. For leveraged bond funds, meaning funds that borrow money using the purchased bonds as collateral, you will find a lot more funds that don’t meet this threshold.
Management Tenure: I like to look for funds that have at least one Director who’s been with the fund for over 5 years.
Bonus Point (Closed-End Funds ONLY):
Premium/Discount to NAV: Closed-end funds sell an initial number of shares, then are barred from issuing additional shares in the future. Over time, original shareholders sell their stakes to new holders, creating a new price in the market that may diverge from the net asset value of the fund. If a closed end fund is trading at a premium to its Net Asset Value (NAV), you would be paying more than you ultimately expect to be returned in principal when the bonds expire. Because of this, I like to purchase funds which trade at a discount to NAV when I can as opposed to a premium. This concept is not relevant to open funds, because by their nature they sell to new investors at NAV.
As you look through a fund’s prospectus, zero in on the 8 factors above (9 if you are looking at closed-end funds). These impact the biggest risk and reward fulcrums to your potential investment.
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