Don't Buy Bond Index Funds or Individual Bonds

Actively managed mutual funds that invest in stocks have gotten a bad rap -- for good reason. Their biggest shortcoming is that, with few exceptions, their expense ratios are disgracefully high. Largely because they charge too much, about two-thirds of actively managed stock funds fail to match their benchmarks over the long run.

But for one giant asset class, actively managed funds with reasonable fees are far superior to index funds. When it comes to bonds, I think actively managed funds are a better choice than index funds.

Why? Let's start with the construction of indexes. Indexes are almost always assembled based on the market value of their component securities. In the case of stock indexes, market value is determined by multiplying a stock's price by the number of shares outstanding. So Apple (symbol AAPL), the world's most valuable publicly traded company, is the biggest holding in Standard & Poor's 500-stock index, which mainly tracks shares of large U.S. companies. Apple's gigantic market capitalization is the product (literally) of 937.4 million shares outstanding and its share price of $701.91 as of September 18. That gives Apple a market cap of $658 billion. At that size, it's 4.5% of the S&P 500.

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In other words, Apple is the index's biggest component largely because investors love it. Put it another way, weightings in the S&P 500 are based essentially on investor enthusiasm for one stock over another.

Now look at bonds. Bond index funds use the exact same methodology as stock index funds. They multiply the number of bonds an issuer has outstanding by the market price of those bonds. But bond prices don't oscillate nearly as wildly as stock prices.

More important, companies or countries issue bonds mainly based on how badly they need the money. Thus, the most highly indebted bond issuers tend to float the most bonds. "The biggest debtors make up the largest proportion of a bond index," says Eric Jacobson, director of fixed-income research at Morningstar. In picking companies or countries to lend money to (which is what you do when you buy bonds), the last thing you normally want to do is lend a lot to an issuer that's deeply in debt.

Consider Barclays Aggregate U.S. Bond index, which is often seen as a proxy for the U.S. bond market. Treasury bonds and notes account for 31% of the index, and government-backed mortgage securities account for 28%. Why so much? Uncle Sam has issued a ton of debt securities because U.S. tax receipts don't come anywhere close to the cost of running the government. So have Fannie Mae and Freddie Mac, which issue vast quantities of mortgage-backed securities.

Treasuries have been strong performers for many years, and that has boosted performance of the Aggregate index, as well as that of pure Treasury indexes. But ten-year Treasury bonds today yield a paltry 1.8%. At that yield, I'd argue that it's pretty hard to find a worse investment, and I wouldn't put any money in an index that has nearly a third of its assets in Treasuries

There are other reasons to dislike bond index funds. The bond market is much less efficient than the stock market. Most trading is still done over the phone. That means a good bond fund manager can beat an index more easily than can a stock manager. Over the past three years, the average actively managed bond fund has beaten the average bond index fund by about one-half percentage point per year.

My distaste for bond index funds means I also have little regard for bond exchange-traded funds. After all, nearly all ETFs follow an index.

What about individual bonds? I think they're a bad deal for individual investors. Think of them as a roach motel. You can buy them, especially at their initial public offering, at pretty reasonable prices relative to their value.

But you get killed when you sell. I've had numerous clients come to me with portfolios of corporate and municipal bonds. When I've put them out for bids through a brokerage, the bids come in at 3%, 4% or even 5% less than their worth. So you're often better off sticking with these bonds until they mature, which can be problematic if you need the money right away.

Many people argue that you should buy a laddered portfolio of individual bonds, maturing in, say, two, four, six, eight and ten years -- and simply wait for each to mature before buying a new one. You save the expense ratio that a fund would charge, and you always know exactly what you'll get back when the bonds mature.

But what you don't know is what inflation will do to the value of your principal. Nor do you know if your bond will be called away -- that is, redeemed by the issuer before maturity. That's a particularly acute problem with municipal bonds. What's worse, a default of even one bond in your portfolio could cost you dearly.

You're much better off investing in a good actively managed bond fund. You can choose from among many solid funds. Vanguard Intermediate-Term Tax-Exempt (VWITX) gives you a high-quality portfolio of munis for just 0.20% annually. Pimco Diversified Income (PDVDX) invests in high-yield and investment-grade corporate bonds and foreign IOUs. Metropolitan West Total Return Bond (MWTRX) invests in corporates, mortgages and some Treasuries.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area. He and several of his clients own shares of Apple.

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Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.