Sunday, October 18, 2009

Bond Mutual Fund Fees

A recent Wall Street Journal article by Jason Zweig discussed the annual costs of owning a taxable bond fund. He referenced Morningstar research which showed that the average taxable bond fund charged over 1% in annual fees with some bond funds charging as high as 2.98%. His recommendation? Look to a bond index fund rather than an actively managed bond mutual fund. The example Zweig gave was the Vanguard Total Bond Market Index Fund which charges only 22 basis points, or 0.22 of 1%....about 1/5 what the other funds charge on average. Another example of an inexpensive fund group would be Dimensional, which charges approximately half of what Vanguard charges. (Blue Haven Capital uses both Vanguard and Dimensional products for its client portfolios).

A third choice is for the investor to use a money manager to build his or her own bond portfolio using individual bonds. The trick here is to make sure that the money manager really knows bonds. Most retail stock brokers are not familiar with bonds and will often purchase bonds at very uncompetitive prices. By finding a money manager that really knows bonds, the investor can capture the low cost structure that Dimensional and Vanguard offer, but also end up owning a highly customized bond portfolio which provides exactly the income stream the investor needs. (Blue Haven Capital also builds portfolios using individual bonds).

It pays to shop around when looking for fixed income products. ETFs, funds, and individual bond portfolios all make sense, but not at the prices that Morningstar found.

Thursday, October 8, 2009

The High Cost of Waiting for Interest Rates to Rise

We were recently asked by a foundation to quantify the cost of sitting in cash (money market) with a $1mm portion of their fixed income portfolio. The foundation assumed that rates would be going up starting in 2010, and that one alternative would be to buy a 3 year agency bond with a one time call which would occur 12 months from now...often described as a 3yr/1yr 1x call. Is it better to sit in cash and wait for rates to rise, or is it better to get invested now in what could be a rising interest rate environment?

We assumed that money market rates were 1/4% and that starting in 2010, money market rates would increase by 25basis points (1/4 of 1%) every quarter for the next three years. We also assumed that the market could give us a 3yr/1yr 1xcall Agency bond at 2.00%.

At the end of 12 months, sitting in cash (even with rates rising) has cost the foundation $15,625. At this point, if the bond gets called, the foundation will need to reinvest in another bond. If the bond does not get called, the foundation will hold the bond for another 24 months. At the end of that next 24 months, even with rising rates, sitting in cash has cost the foundation a total of
$18, 125.

Unless one thinks that rates are going to increase dramatically in a very short period of time, the cost of sitting in cash is too high. If the interest rate curve were flatter, it might make sense. But, with low money market rates combined with very attractive 3 and 5 year bond rates, it pays to grab some of those yields right now.