I recently received a letter from a client inquiring about the bond funds and individual bonds:

James,

I’m sure you saw or heard about the barrons.com article about oversold bond funds paying ridiculously high rates of return with ridiculous discounts from net asset value. Tell me why again we should not be pursuing a strategy of buying other people’s funds that have had the crap kicked out them of versus buying our own individual debt issues that have had the crap kicked out of them, yet with far lower yields?

If you focused your analysis work on these high-yield closed-end junk and muni bond funds versus individual stocks, it seems you could make a lot more money for your investors and yourself, even after paying the expenses of those closed-end funds… expenses that are baked in anyway.

This was my response: 

Dear Client,

I appreciate your honest feedback; however, the assumptions and conclusion in your email and the Barron’s article written by Amey Stone are incorrect for numerous reasons which I’ll delineate in order:

1) Both our individual bonds and high yield bond funds are distressed over the past year due primarily to plummeting energy prices.  However, our individual bond yield is higher in than most funds.  The current yield to maturity for your portfolio is greater than 13% – much higher than almost all high yield bond funds.  As an example, the Vanguard High Yield Corporate fund has a 30-day SEC yield of 6.2%.  That said, we will likely not achieve that yield due to potential defaults though bond funds have the same risk.  In addition, yield isn’t the only consideration for investment as one may achieve a higher rate of return due to total return from a discounted issue.

2) You may be referring to closed end funds.  If so, closed end funds achieve a higher yield by using leverage.  We can certainly do the same boosting the yield from 16% – 20% by using leverage, but that strategy can lead to much greater losses and is a very dangerous proposition.  Closed end expenses are certainly not baked in as they are generally much higher.  As an example, in addition to it being easier to manage than purchasing individual bonds for our clients, our firm would make more money if we pooled all of our clients into a closed-end fund.  In addition, unlike our fees the expenses in mutual funds may not be deducted from one’s taxes since funds don’t have a fiduciary responsibility.

3) One may not control interest rate risk when investing in mutual funds.  If one of our clients panic sells a position(s), the rest of our clients may see a price decline in the issue due to the sale of the bond, but as long as the issue doesn’t default before maturity our clients holding individual bonds will receive continued interest payments and their principal.  However, when we have to sell the same issue for mutual fund clients it in turn hurts all clients in the fund.  As the fund is open ended, it often leads to additional redemption requests (which has been the case in recent months) in turn creating a vicious cycle in which a mutual fund investor may not receive their principal back.  Thus, the mutual fund investor not only takes on credit risk, but also interest rate risk.  Though closed end funds are less susceptible to interest rate risk (though not immune when using leverage), they also are priced by secondary demand and contain other risks.

4) The Barron’s journalist seems like an intelligent individual.  However, journalists generally have little idea of how actual money is managed.  It is why when reading an article I always attempt to determine their qualifications and their bias.  In this case, the author is clearly intelligent having graduated from Yale and Columbia, but her undergraduate degree is in Women’s Studies and graduate work in Journalism.  She has always been a journalist having never managed money nor worked for a financial institution and has no fixed income expertise. See her bio here.

Honestly, it would be a lot easier to do what 98% of our competitors do by simply charging their clients 3/4% to 1% and merely research other money managers.  Yet, the benefits for our clients owning individual bonds is worth the additional staff and effort.  I know you are very busy, but I discuss our current strategy spending a great deal of time on fixed income during a recent client presentation.  This YouTube presentation also discusses many of the benefits of owning individual bonds:

Should you have additional questions or not agree with any of my assertions, please don’t hesitate to call or email me directly or your lead financial advisor, Chris Rolf, CFA.  I hope you had a wonderful Christmas with your family and that you enjoy a happy, healthy, and prosperous New Year.

With warmest regards,
Jim