FOOL'S EYE VIEW
Bond Funds Are Riskier Than You Think

By Maynard Paton (TMFMayn)
October 10, 2002

One of the side effects of the stock market suffering a few bad years is that fund managers switch to plugging corporate bond funds. Advertisements for these funds are now as plentiful as they were for share-based funds a few years ago and that, in itself, should be a warning sign.

Anyway, I was looking at one of these adverts the other day and was struck by some of the language that it used. I don't want to have a beef about the particular fund or fund manager -- all the ads are essentially the same anyway -- but I really don't think they convey a proper sense of the balance of risk and return in the investments. This particular ad kicks off with the following:

With the current low interest rate environment and volatile equity markets, you will be aiming to maintain a sensible balance of investments in your portfolio.

This is designed to make you feel as though you'd be doing something sensible if you invested in the fund, but both the points are red herrings. There's no more reason to invest in a bond fund in a low interest environment than there is in a high interest rate environment. In fact, the biggest threat to shares is probably that inflation and interest rates rise and that would also be bad for bonds.

"Volatile equity markets" is a euphemism for "they've gone down", but what has happened in the recent past is not a reason for investing in different assets. What matters are the returns offered by different investments compared to their risks and how well that fits in with what you're trying to achieve. Since bonds and shares are traded in a market, investors are adjusting the risk/reward balance to appropriate levels every day, whatever the interest rate environment.

The advertisement continues...

The xxx bond fund has an estimated, and highly competitive, gross income yield of 7% per annum. (est. gross redemption yield of 6.84% p.a.) and could be the alternative you are looking for. However, income from the fund is not guaranteed and, unlike a building society, the value of your capital may go down as well as up

So after showing off about a 7% "gross income yield", they concede (because the rules say they have to) that the income isn't guaranteed and that even the value of your capital might go up or down. When you think about it, the yield of 7% isn't much to shout about even against building society rates of, say, 4%, if the value of your capital might go up or down by 10% or more. You might think, in fact, that the focus on the 7% income yield is rather missing the point.

No free lunches

There's more about bond yields in this article, but clearly we're now getting to the meat of things. There are no free lunches with investing and that juicy-looking 6.84% redemption yield is there for a reason. Put simply, investors think there's a fair chance that some of the companies that have issued these corporate bonds may go bust.

The yield quoted is net of charges, but unfortunately the advert doesn't tell me what these are. Guessing that they're up at the 1% mark (most are at least this), then we've got bonds that offer a yield of getting on for double what you can get from the Government, a bank or a building society. In fact, at 8%, the yield is pretty close to what many people are expecting those "volatile equity markets" to produce in coming years. So it's factoring in a lot of risk.

On top of all this, the fund trades bonds, instead of holding them until they mature. Since bond prices move around (depending on changes in interest rate expectations and the perceived creditworthiness of the borrowing company), your capital will go up or down depending on how well the fund manager manages to play the market.

So we've got companies potentially going bust on you, returns up towards the sort of level you might expect from shares and fund managers playing the markets. Does that sound familiar? It's not a million miles away from the position with stock market funds. So if you're thinking of a bond fund as a safe, secure investment, then think again. In investment terms, safe and secure means going for gilts or, at a pinch, cash in the bank and settling for that 4% interest rate.

Make sure you know what you're getting into

If none of this is making much sense then, at the very least, you should make sure it does make sense before you invest in a bond fund. The past is littered with examples of investments going wrong and, in just about every case -- split capital investment trusts, Equitable Life, endowment mortgages -- the majority of investors didn't have the first idea what they were investing in.

Corporate bond funds are sold as a form of investment with a balance of risk and return somewhere in between cash and shares. The trouble is that it's very hard for the typical Fool to know just where any particular fund lies on that scale. The best indicator is the redemption yield that a fund offers. The further it gets above what you might expect from gilts and the closer it gets to what you might hope for from shares, the riskier it's going to be. A lot of these funds look to me like they must be pretty risky.