Financial Toxic: Bond Funds

This is the third installment of my financial toxic series. In this article, I am going to look at something that most people like financial professionals consider as “safe”, bond funds. Bonds are considered safe because the financial textbooks say so but I am going to show you the opposite.

Before I move on, let me repeat my disclaimer. This article is an expression of my personal opinion. I am neither a licensed financial adviser nor a financial expert. I am only an engineer. Here is the difference: Financial advisers and financial experts are trained to obey everything written in their text books without question while engineers are trained to think and analyze logically.

Next, I shall set the definition on the topic itself. There are basically 2 types of bonds based on the credit ratings of the institutions that issue them. Investment grade bonds and junk bonds. In this article I shall focus entirely on the investment grade bonds. These are the textbook case of “safe” investments but in reality they are toxic and I will show you why.

There are basically 2 types of poison. Poisons can either kill you immediately or kill you slowly over a long period of time. Financial toxic can work in both ways as well. In my previous installment, I have explored on whole life insurance plan. Whole life insurance is an example of slow acting poison. You will not be bankrupt immediately after you bought it but in long term it sucks your money away which you could have put to use to grow at a much better rates. Your finances will die a slow death because of it. Bond funds work in the same way. It will kill your finances slowly but surely.

I shall address the characteristics of this toxic now.

Effects of inflation.
I suspect many people may ask on how can such a safe investment be toxic? Let me give you a magic word to explain it all – inflation. The higher grade the bonds are, the lower will be their coupon yield. So, if you opt for only the highest graded bonds, you will get the lowest interest. The interest will be lower than the rate of inflation. Even if the underlying bond issuers never go bankrupt you will still be poorer in terms of purchasing power.

Investing in bonds for long term is like buying a huge block of ice, put in under the cover of an umbrella under the tropical sun. The ice will not vanish in split second but you can be sure that it will only continue to melt. In long term, the ice will cease to exist. This is the same for bond funds. Inflation will eat away your assets. You may have more money but the amount of things you can buy with them will be lesser. This investment will only make you poorer.

So, if there are financial advisers trying to promote bond funds to you, ask them about the effects of inflation.

Some people may ask, “How about short term?” The answer is below.

Sales and management charges.
All mutual funds come with sales charges. Whether they are “front-loaded” or “backend-loaded”, they are still sales charges. This is the way financial advisers and insurance agents make money doing your “financial planning”. This is also a good opportunity for those who are good in sales to make a lot of money.

The existence of sales charge means you can never hold your mutual funds for short term. Let me give you a numerical example. Suppose the sales charge is 5% of the investment amount and you have invested $10,000. Out of the $10,000, $500 will go to the financial adviser as commission for his or her effort in getting you to part with your money. So your actual investment is $9,500. In order to break even in a year, your $9,500 investment must grow by 5.26% in that year.

Think. How likely is it for a low yielding bond fund to generate 5.26% in a year? In reality, the first few years of your investment is to make the money for your financial adviser. Therefore we rule out investing in bond funds for short term.

Capital appreciation.
Apart from coupon yield, bond prices can also enjoy capital appreciation. Bond prices are very sensitive to the prevailing interest rates. They move in opposite directions. When the interest rates go up, bond prices go down. When the interest rates go down, bond prices go up. It is a good idea to buy bonds if the interest rates are about to go down and sell bonds if the interest rates are about to up.

I have attended several sales talks for bond funds. In all the talks I have notice a common thing. All the presentations had various charts to show that the interest rates are always going down. Why? They are just doing their jobs in making you part with your money. By the way, they are not completely wrong. If you always tell people that the interest rates are going down the probability of you being right is 50%. You are right 50% of the time.

I challenge you to test out this theory of mine. Find any investment talk or seminar on bond funds and attend some of them. I can guarantee you that you will always see “proofs” on the interest rates going down. Don’t be too hard on them. They are just trying to make a sale.

Having said all these, I am not ruling out that bonds can appreciate in value but that does not mean the investor can benefit from them. The only way you can benefit from the appreciation of bond prices is for you to sell the bonds immediately after they have appreciated in value. If you leave them in your bond fund for long term, the value will drop again when the interest rates go up.

The appreciation of bonds prices is only beneficial for bond traders, not for investors of bond funds.

Conclusion
I have put up the above 3 points to show you the reality of bond funds. I hope you will realize by now that bond fund is a slow acting poison. It may benefit the person to sells it to you but it can only make you poorer. I doubt you can find this truth in any of the financial text books.

The rest is up to you. Who will you choose to trust, an engineer or a financial expert?

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