Choosing and buying a bond fund

A couple of days ago, I decided to “invest-by-putting-a-toe-in-the-water” and bought some shares of Loomis Sayles Bond Fund (retail class, symbol LSBRX). To be honest with you, investing in bonds and bond funds are still a mystery to me, despite knowing how bonds work in theory.

Unless you have plenty of money (and time) to invest, buying individual bonds can be tricky. Instead, in order to obtain diversification within bonds, most investors choose to buy bond funds. As a complete newbie to bond investing, I definitely fell into this category. The purpose of many bond funds is to provide current income (in the form of dividend payouts), though some also aim for capital appreciation. The prospectus for LSBRX stated that it had both of these goals in mind.

Here’s the process I went through in deciding whether or not to invest in LSBRX:

I’d first checked into bond funds and bond ETFs (such as TLT and AGG) in Q3 and Q4 2005, but at that time, they appeared to be unattractive investments:

1. My brokerage, Schwab, didn’t have too many attractive no-load bond funds to begin with;
2. Interest rates were still low but rising, and bond funds’ returns didn’t seem too much better than the rate I was currently getting on my money market fund (which was also more liquid);
3. I felt that TLT and AGG, being ETFs, acted like stocks at times rather than their underlying assets, and so I questioned their ability to diversify my holdings.

This month, I again checked LSBRX and noticed that its yield had increased to over 6%. In addition, YTD return was at 3%, making total returns around 9% so far, before taxes.

Note: You can get into trouble quickly by just focusing on a fund’s yield. Yield, calculated as dividends/price, can increase because dividends are increasing or price is decreasing, or some combination of the two. For example, if you have a $10 fund that pays out $1 in dividends a year, then its yield is 10%. If in the next year the fund contines to pay out $1 but its price drops to $5, then its yield suddenly rises to 20% not because it’s paying out more but because the divisor is less! As always, calculations and data are dumb unless you understand what’s behind them. In this case, LSBRX’s price had continued a slow but steady uptrend, so I felt surer that its yield had not increased due to an eroding price.

I looked into the fund’s expenses and distributions records. LSBRX has a total expense ratio of 1%, which includes a 0.25% 12b-1 marketing fee. Generally, the latter isn’t seen as a great thing because it means the fund “sells” itself to investors. Still, its 1% expense ratio was lower than average. It pays out dividends every quarter, with around double the amount of a regular payout coming in December. The last time capital gains were paid out was in 1998, which doesn’t mean it won’t happen again, but at least shows that the fund’s managers might be aware and consciously trying to minimize capital gains taxes for their shareholders. (The interplay between capital gains taxes and mutual funds is complex and worth reading about before investing in any type of fund.)

LSBRX has outperformed the multisector bond index, according to Schwab’s website, though it underperformed Lehman Brothers Credit Bond from 2001-2003. I didn’t really like this, but perhaps it’s impossible to find an investment that always outperforms its index. I would have liked to known if the indices being chosen were the correct benchmarks, however. You’d be surprised how often they’re not.

LSBRX’s prospectus showed the following: it has been managed by the same two people, Fuss and Gaffney, since 1991 and 1997, respectively. This is usually a good sign, assuming the fund’s performance has been good and consistent under their management. The fund falls into the multisector bond category, meaning its holdings are comprised of both government and corporate bonds of various ratings. At least 80% of assets are invested in fixed-income securities, and they may invest up to 20% in foreign securities and up to 35% in lower-rated fixed income securities (also known as “junk bonds”). They also may invest in non-market securities, which do not have a direct correlation with intrerest rates. (Most of the wording in this paragraph is excerpted from LSBRX’s prospectus.)

I also read the fund’s Statment of Additional Information (SAI), which, if I understood correctly, revealed that Charles Schwab was a major partner of the fund in terms of its role as “distributor” and its clients combined holdings. I was a little wary of this relationship, but having done my own homework and research, ultimately decided in the end that I was still willing to invest some money in the fund.

The SAI also showed that Fuss and Gaffney have significant amounts invested in the fund. Fuss has over $1M, and Gaffney somewhere between $100K-$500K. While this doesn’t serve as a guarantee of the fund’s performance, at least the two fund managers have a vested interest in seeing the fund perform well. You’d might be surprised at the number of funds out there whose managers either have no vested interest in the fund, or only a token amount of $1,000!

The Loomis Sayles website also has a list of each of its funds’ holdings, including a long list of holdings for LSBRX for the previous month. I like this transparency. The average maturity of bonds in LSBRX is about 7.5 years. To be honest, I wasn’t entirely sure what to make of this. Experts in the press have recommended investing in shorter-term bonds, but I don’t know if they’re talking about government or corporate bonds, or if it matters.

Finally, I would have also liked to find the fund’s tracking error, to confirm that the fund was actually being actively managed; however, I have not yet found an easy way to do so. Someone told me Morningstar has this information, but I couldn’t find it when tried their trial subscription. Any ideas?

After weighing all the information above, I decided to start out investing a small amount in LSBRX. Here’s a summary of why:

1. LSBRX is yielding higher than my MMF;
2. Distributions from either LSBRX or my MMF would be taxed at the same rate (I believe);
3. LSBRX might result in some additional capital appreciation;
4. It appears to be a consistently well-performing fund;
5. It diversifies my holdings;
6. I don’t have the understanding or access to invest in bonds as much as I do in stocks, so LSBRX might be one of the few ways for me to do so.

If my investment turns out to be successful, I might continue to dollar-cost average into the fund, up to a certain amount, since current income is not one of my main investment goals.

So, to anyone who has more experience with investing in bonds and bond funds, I’d love to hear your thoughts. Did I do ok? Could I have done something different? Did I royally screw up? Opinions? Thanks!

Update: Jason from Zirotti.com was kind enough to provide some feedback and information that are really useful. See comments below. Thanks Jason!

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