As passive funds take a center stage, the number of bond funds on the market is skyrocketing. Most get into passive funds because they can't be bothered to select individual bonds (i.e. buying individual bonds vs. bond funds), which means that investors have to judge a fund from a very simple cover.
I'll go through a few key things to look for to judge a bond fund's performance, but understand that all of the data points that follow can be found on any ETF issuer's website, or in the fund prospectus.
Average Duration and Bond Fund's Performance
The average duration of a bond fund says a lot about how the fund will respond to interest rates, and thus perform. The average duration for a bond fund is the weighted-average of bond cash flows from coupons (interest payments) or maturation (when principal is returned to investors).
A bond fund with a high duration will be more sensitive to interest rates. A fund with an average duration of 5 years will be less sensitive to interest rates than a fund with an average duration of 10 years.
The average duration of a bond fund should, in general, match the period of time in which you expect to keep your investment dollars in the fund. If you're planning to buy a car in the next year, putting your savings into a 30-year bond fund would put you at serious risk of losing money as interest rates change. A fund with a lower average duration would be a much better pick. That's why even if you invest in bond funds, it is important do build a diversified bond portfolio, just like you would build a diversified stock portfolio.
Bond funds have only complicated fixed-income investments. At any given time, a bond ETF can trade at a discount or premium to its net asset value – the current value of the bonds in the portfolio.
If a bond portfolio has a current market value of $30.00 per share, but the ETF trades for $29.70 per share, then it trades at a 1% discount to NAV. If the ETF traded at $30.30 per share, then it would trade at a 1% premium to NAV.
So why does this matter?
You'll need to know the NAV premium or discount in order to know the usefulness of the next piece of information: yield to maturity. Unfortunately, many new bond funds are relatively illiquid as the bond market has no central exchange, and trading volumes are lighter. Less trading volume results in larger bid/ask spreads, and thus bond funds trade at premiums and discounts to the actual value of the bonds backing up the fund.
Yield to Maturity
The yield to maturity is the rate of return an investor would receive if all bonds are held to maturity. This is an important indicator of the bond fund's performance. There are just two problems with taking this number at face value, though. First, the yield to maturity measure does NOT take into consideration the fees on the ETF. This is huge – if your bond fund has a YTM of 1% and fees are 1%, you're getting nowhere fast!
Secondly, the YTM for your bond fund is calculated on the fund's net asset value, not the current price of the ETF.
If you pay exactly the NAV to buy a bond fund, then the stated YTM is 100% correct. If you pay a premium, it'll be lower, and higher if you get the fund at a discount to NAV.
Bringing all these concepts together, suppose you bought a fund that had:
- Average duration of 3 years
- A fee of 1% per year
- A stated YTM of 4%
- A premium of 1%
The stated return is 4% if you go solely on the yield to maturity. However, adding in the fees and the premium you pay for the ETF, your returns will be more like 2.64%, a BIG difference compared to the stated return of 4%.
Feeling Safe in Bond Funds
Bonds are generally regarded as the safer counterpart to stocks in a simple asset allocation model. Safety, of course, is entirely relative. Bond funds aren't that much safer if you lose money for owning them, or if you buy funds that don't match your risk profile. Plus, the price, or NAV, of bond funds is inversely correlated to yield. As yields rise, which they will in the coming years, bond prices will fall. This has led some to question whether the bond bubble will pop soon?
- Don't use yield to maturity as a perfect measure of your returns. Bake in the fund fees, and include any premium or discount for the bond fund. Returns are lower than you might expect.
- Match a fund's average duration with your willingness to accept volatility. Long-term bonds are no place for short-term savings, just as short-term bonds aren't the best place to keep long term investment dollars.
Are you invested in bonds? Are you concerned about a bond bubble? What key features do you look for in a bond fund?