Bond Series - How bond mutual funds can become money traps

Still reeling from the rollercoaster ride that was 2022 in the bond market? You're not alone. In this episode,  we dissect the intricate world of bond mutual funds, breaking down why the rules of the stock market don’t always apply. Expect to emerge from our conversation with a new perspective on how overpaying for bonds can feel like a tightrope walk over a pitfall of limited returns. We don't just skim the surface; we scrutinize the common traps investors fall into when they treat bond funds like their stock counterparts, and we arm you with the savvy to make choices that serve your portfolio, not strangle it.

We dive into the murky waters of mutual fund fees, unveiling what they entail and the significance of aligning them with a fund manager's performance. This isn’t just about numbers; it's about getting under the hood of bond mutual funds, understanding their contracts, and grasping how market flows can either buoy or batter your investments.

We round off with a candid look at the limitations that mutual funds can impose on an investor's autonomy. Here's a sobering thought: market flows, and the behavior of other investors can hijack your mutual fund's performance, often leading to unintended consequences for your hard-earned money. We lay out the strategic crossroads faced by investors in today’s volatile bond market, urging a thorough reassessment of whether bonds merit a place in your portfolio. Tune in and equip yourself with the insights needed to tread confidently in the bond market's shifting sands.

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Transcript

Speaker 1: 0:08

Welcome to Ditch the Suits podcast, where we share insights nobody in the financial services industry wants you to know about. We're here to help you get the most from your money in life, so buckle up and welcome to Ditch the Suits. Well, with that creepy laugh, welcome back to Ditch the Suits podcast, steve Campbell, with Travis Moss. This is going to be our second episode in a three-part series where we are talking about fixed income and bonds and are they right for you?

Speaker 1: 0:36

First episode, in case you missed it, we just laid the groundwork for really what is a bond, and we had kind of talked a lot about bond mutual funds. But what if we pose the question to you today of how bond mutual funds can actually become money traps if you're not careful? And why do we say this? 2022 is a really tough year for those that were bond mutual funds. As they looked at their statements, didn't understand why they were seeing their portfolios being down, how to make sense for it. So, now that we know what bonds are from episode one, travis, why don't you talk to us really then about bond mutual funds and really maybe comparing it to how a stock mutual fund could work?

Speaker 2: 1:13

Yeah, I think some people sometimes they go. Well, investments are all the same, all mutual funds are the same, and my mutual funds were down, whatever percent. Well, bond mutual funds were down. It was very reasonable and not all of them, but the vast majority of them that a typical person would be investing in coming into 2022 were down like it was not. It would be normal if you were down anywhere from 13 to 25% in your bonds, which and then you would think, okay, well, I probably made it all back to following you, didn't you know? They're still down. The US aggregate bond index is still down from January 1, 2022, all the way through January 1, this year, still down about 7.5% or so.

Speaker 2: 1:55

So there's something going on there and that's what we're talking about here. If you understand how the parts are made or how these things are put together, you're going to be much more empowered to make good buying decisions. Because I do think that they can be money traps and we get in the mistake of thinking that, whether, all the same, all mutual funds are the same, all bond funds are the same. You know, like, like it's just or just pick them based on some, you know three year performance or something like that, and we group it all together as if when we like when we did a whole long series on index investing right, and I just buy the index is because the index is, you're always beat the active managers yeah, until you get 2022. And until you get creamed because you didn't realize that you're overpaying by 10 or 15% for your bond funds.

Speaker 2: 2:48

And the problem there is is that we're grouping things that are actually categorically not like each other together.

Speaker 2: 2:54

We're saying you know, there's really not that much difference between a bond mutual fund and a stock mutual fund and therefore you should treat them exactly the same way when you're looking at buying them, and that's just factually wrong. It's incorrect, it's lazy, it's salesmanship on the industry's part, it's misleading, it's just garbage. If you overpay for a stock, if you accidentally overpay for the stock, you go out and you buy Apple. And let's say you bought Apple four or five years ago and you paid 10, 15% more than it was probably worth, based on how much money it was making and you know if you appraised or whatever. So what Apple is going to make so much money in the future and it's infinite. You can just hold that until it catches it back up right until it has a couple of good years and it all kind of balances out, you'll be fine. In a lot of cases you can still make a lot of money, even if you buy it at the wrong price. You're not guaranteed anything, you're not locked in.

Speaker 1: 3:49

Yeah.

Speaker 2: 3:51

If you buy an equity mutual fund, that's like you know. You're about a whole portfolio, even if you overpaid by 10% for the portfolio. Stocks are constantly adjusting to inflation and the time value of money, so it's going to naturally increase over time anyway, You're going to be able to ride that long enough. Now your long-term average return might dip a little bit, but you could still make money on it. You can still come out positive. And you're not coming out positive because of any kind of contractual terms. You're coming out positive because there's an infinite amount of outcome. There's a limited downside it can only go to zero but then on the upside it's infinite what a business can decide to do to make money, or how a business can become more profitable, or how a business looks compared to other businesses. You know that's a you know wide, open discussion and that's what's very, very, very different from as we talk about stocks and how those are very different from bonds or stock mutual funds and bond mutual funds.

Speaker 1: 5:03

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Speaker 1: 5:48

Well and you know my brain goes a mile a minute I'm trying to think of like word association for people listening to this. You can tell me if this analogy is wrong. It's almost like if you had two different. If you had $100,000 to make an investment, you could either, you know, pay a small business owner who builds homes as a constructor, give him $100,000 to start his business so he can go build as many homes as he can and you'll reap in some of the profits for every home that he makes. There's risk involved with that. Or you can give $100,000 in the form of a mortgage that's fixed and the whole idea is you'll collect money over the years, but it's a fixed amount. You know what I mean. You know what you're going to get, hopefully, at the end of itself, for the price. So in one way you could pay a developer to go build all these homes and you could reap in the profits, but they could also go under. So there's a risk to that versus kind of the fixed income. But just to say those are the two same type analogies would be very wrong.

Speaker 1: 6:38

When it comes to investing, I don't think we always think that way. Because we hear the word mutual fund, maybe we feel like that's the binding thing that makes them the same thing, until you look under the hood and all the moving parts and it's like no. Owning a stock, owning an equity, is very different from owning an IOU to a government or municipality, and so I think just even understanding these two relationships to a stock mutual fund versus a bond mutual fund can be really eyeopening to the fact of. You know I was even thinking about as you were talking to as well.

Speaker 1: 7:08

I think when it comes to stocks, even with all the ups and downs of the markets over the years, people have made money back relatively quickly, even if they've taken a big dip in their portfolio. That through the election, through COVID, through all of these changes. That when it came to 2022 with their bonds, it was like, well, it's going to be the same thing, right, I'm going to lose some money 1525% but I'll get it all back until you didn't. And now you're left kind of wondering, well, what happened? Because I thought this was the same thing as what happened with my stock. So maybe just that go for people experiencing that was really challenging. So I think even just understanding these differences will be really helpful.

Speaker 2: 7:44

Yeah, I think a different phenomenon happened with 2022, whereas people thought that they were in something safe and, in their opinion, it's no longer safe, Because I thought I was in something that was supposed to protect me and it didn't protect me. And it's like you know, if something is, if you buy something and don't use it properly, who's at fault? Right, Is it the manufacturer or is it you, because you didn't use it per the instructions? And that's kind of the problem with the bonds If we don't understand what they are and how they're designed, then we could buy something that is factually pretty safe but get very negative results from it because we're not using it correctly.

Speaker 2: 8:30

When you think of buying a mutual fund because we're going to pick on mutual funds here a little bit when you think of buying a mutual fund, let's say you go and you go okay, I'm going to buy a stock mutual and you go to Vanguard, or you go to American funds or you go to Fidelity. What's one of the first things you do? You look at the list of funds and you look at the one, three, five and ten year performance and you go I want one that's performing good. Right, I want the four-star fund or the five-star fund or the one that averages 10% a year, or whatever. You're looking for the higher performance. I mean, if you looked at two funds and you said this one made 8% last year or per year over the last three years and this one made 10% over the last three years, you're probably going to pick the 10% one because, as far as you can tell, that must be a better fund, Right? So you're going to look at the average performance. Maybe you would look at what the fund actually buys. You might say, okay, what are the top 10 holdings? Or top 20 holdings, which is typically what they put in front of you and they'll say we own Apple and Amazon, blah, blah, blah. Right, here's what we own. And you go okay, I know all those companies. That sounds like a good investment.

Speaker 2: 9:31

And then you'd also look at fees and you'd say, okay, how much fees do I have to pay for this thing? And one of the funny things with fees fees are included in the damn performance. And we don't remember this sometimes, If you make 10% a year and the fee was 1.5%, but they already took the fee out. And then the other fund made 8% a year, but the fee was only 0.1% a year, but they already took the fee out. Which fund is better? Right, Probably the one that made 10%. But the question there is is were they investing the same? Was that the design of it? Right, Like, what was that fee actually paying for?

Speaker 2: 10:09

But with a stock fund, we're going in and we're saying I want to know how well the stock pickers are that are picking stocks in here, right? Or I want to know how this index performs against another index, Right? And so we're comparing. Everything that's inside of each of those funds is exactly the same, Right, Like they're. Well, not exactly, but they're buying equities. They're all playing the same game. They're not as we get into bonds. They're not buying stacks of contracts with fine print, Right, they're out there and they're buying stocks and the stocks are doing what stocks do. And so that makes a little bit of sense to say do these people actually know how to pick these things? Right, and when am I actually paying these people to pick these things? And am I making money for paying them to pick these things? And you know what type of stuff are they actually picking? And then we turn around to the bond funds and we go we should treat them exactly the same.

Speaker 1: 11:07

Well, and I think that's probably the biggest differentiation, right? So when you look at the stock mutual funds, you're going to look at those holdings, the fees, the previous return, but then again, when you then start to think about okay, travis, so I get it, you've told me now for a couple minutes that these are very different. Well then, what are the biggest differentiations that separates a bond mutual fund from a stock mutual fund? Then, hey guys, steve Campbell with Ditch the Suits Want to take one quick moment to make a big ask. If you haven't already, travis and I would love for you to subscribe to this podcast, but if you haven't, also, we would love for you to leave a five-star rating and review. Your rating and review will let other podcasters know that the show is worth their time. So let's get right back to the episode. And thanks for listening to Ditch the Suits podcast.

Speaker 2: 11:50

Well, so, first of all, stocks have infinite outcome, right, they can. We can buy them. We can screw up the timing. We hold on to them long enough Time is going to be forgiving to us.

Speaker 2: 12:01

But when you buy a contract, you're buying something that's finite. There's a limited amount of time and the terms are already set. The outcomes are already set when you buy it. Or there may be multiple outcomes, like there could be different callability options and stuff like that, but it's, it's calculable, you can actually figure out the range of possible outcome and therefore it's finite and it's normally fairly tight, meaning you're not normally going to buy a bond, unless it's a very distressed organization, but you're not going to buy a bond.

Speaker 2: 12:36

And what you would never do is you can't buy a bond and make 300 times your money in a two-year period. You could do that with a stock. Right, I was going to say you can't do. You can't buy a bond and make like 50%. But you could. You could buy a bond in a severely depressed company or government agency or something like that and their problem goes away and the, the, the, you know resale value either comes up or you know the bond makes it the maturity and you get paid out. So you could make up to, let's say, a 100% return type of thing, or even more in a bond by buying a depressed price. But when you buy it it is. You can already calculate the maximum, and the issue is, the more you can make in a bond that it's like gambling. That means the bigger the bet that you're taking and the less likely you are to actually be getting. That's how you're making that return versus the stock. I can take the same amount of risk buying two different companies, and one can return me 1,000% and one can return me 200% and one could lose me 20%. Right, it's a completely different. It's just fine, it's fixed, there's. There's only so much I can do with it.

Speaker 2: 13:47

And so we think you know that these mutual fund companies out there. I come and give my money to you and what are the mutual fund companies have? They have a. They're managers, right, they're portfolio managers. So they must be looking out for me. They're only going to buy me things that would make me money. That's the idea there, right? Because with stocks, isn't that the idea? They're only going to buy stocks and all stocks can go up. So maybe that makes a lot of sense.

Speaker 2: 14:12

But remember, the bonds are contracts and there's a lot of stuff going on around, like interest rates that are impacting the prices and stuff like that, and when you're buying the bond, you're actually buying the terms, the same terms that were originally designed for the first person in line. You might be the fifth person in line by now. You know this could be the fifth time this bond is being sold. Those terms were were were written for the market environment and the interest rate environment when the bond was actually issued, and that could have completely changed by now. So you got all this fine print, all these things going on the bonds and you know every single one of them is unique.

Speaker 2: 14:54

You're packaging them together and you're saying, okay, well, you know that mutual fun guy, he's supposed to be going out there and he's supposed to be sifting through there and finding the good contracts for me. So as long as that guy is there, you know everything ought to be good and that's just that's. That's not how it works actually, especially not when we're talking about index funds, when you're talking about actively managed funds, which again, the whole world is against actively managed funds and actively managed fund. Yes, there is somebody who's saying I'm going to go through every contract for you, right, and that's where you care about what they did over the last couple of years, because you know it might show whether or not they know what they're doing when they go into the contracts. But an index one, an index fund, says we don't care what the contracts say. You give us money, we go out and buy one of everything. Doesn't matter if the contracts are good or bad, we're going to buy one of everything because you know they'll balance out.

Speaker 1: 15:48

Mm-hmm One, as you talked about.

Speaker 1: 15:50

I think that's why it's helpful going back to that first conversation, to the bond being a contract, because when you say contract, typically it's between one person and one person or one person in an organization.

Speaker 1: 16:01

When you get into a bond mutual fund and you can correct me if I'm wrong it's a number of those contracts all put together, so it's a number of contracts that all have various terms that make up that bond mutual fund, which is very different than just dealing with one individual bond. And so that's what happens is you get your total return bond fund but you don't know the various contracts that make up that agreement. Versus in the stock equity mutual fund, you know the companies, the products, the goods that they bring, the technology, services, like everything that they do, and so I think that's maybe where the biggest difference is when you say finite, just remembering that in that bond fund it's made up of all contracts that have already been agreed upon as to when they're going to mature, and you just own a collective of all different maturity levels that all make up that individual return for you.

Speaker 2: 16:50

And save that idea, because that's the last point that we're going to make is the impact on what's called flows and how that impacts the, the laddering of those contracts as they mature. But let's go back to what we were talking about a little bit ago when we were saying what do you look at when you look at like a stock mutual fund? The same question, for what do you look at when you look at a bond mutual fund? And most people say, well, I look at the top holdings, I look at the fees and look at the previous return, because that's that's all you know how to look at. You know, for if you're a typical, like 95% of investors out there, that's all you know to actually look at, because that's what the industry rubs in your face, right, they put it in big, bold and shiny and arrows pointing here, and the SEC has guidance over what's got to be out in front like performance. It's supposed to be out front and center so you can see actual performance over time and actual performance, not a fees. But think about how silly this is now, how absolutely fundamentally different the bond mutual fund is from the stock mutual fund. The stock mutual fund is like you get bricks of the building that make up the companies. Right, you actually own pieces of them. The bond mutual fund is a mutual fund of contracts with the company. It's contracts, it stacks of paper, it's contracts with them and yet you go in and you approach them as if they're the same thing. Now, if we were to do what we do with the mutual funds, okay, I look at the top holdings, I want to see what they're investing in and I see the same company. I see Apple, amazon, ibm, treasury bonds, whatever. And I go, okay, those are all good. What does it matter if those entities are good? If the contract with the entity isn't good, that's the problem. You can have the best lineup of borrowers basically back to our original vernacular, because that's really what's happening. Right, they're borrowing money from you, you're giving them your money, they're giving you interest and then eventually giving you principal back. You can have the absolute best borrowers. But if the contract is skewed so that you're not actually getting a good deal, what good is it? And that's legit, that happens. And it happens because of interest rates and it happens because of market conditions and everything else that's going on, not to mention with how mutual funds actually work, which will be again part of our last point. But then you also get okay well, that's fine. Holding's okay, I got that.

Speaker 2: 19:23

What about fees? Fees are netted from yields. So again, if the fund is yielding 3% a year, that's 3% net of fees. What are you trying to do? Like, what does the fee actually even matter? It literally doesn't matter. You know, if it's an actively managed fund, the fee is really an acknowledgement that you're paying somebody to sift through those contracts. Then it might matter.

Speaker 2: 19:57

And then that gets you into the other trip trap, which is past performance. So I'm looking at somebody and I'm seeing how they performed over the last five years and it looks like they did really good. So that means that they're going to do really good going in the future With bonds. That's completely.

Speaker 2: 20:14

It's like you got to throw the past performance. You got to be really careful. You almost have to throw it out, because if interest rates were low and now they're high, that's a different environment. What made them money in the portfolio that they had three years ago will be the same thing that could potentially lose the money now. So if you're looking at past history and saying, how will this money manager do in the future based on their past performance, if it's an actively managed fund. But the economic conditions are completely different, past history doesn't literally mean anything and in fact it could get you in trouble because if you look at it and say like let's take an index fund, well, they got 6% average return last three years. So you throw money in and that'll get us to the last point.

Speaker 1: 21:08

And I think this is such a helpful conversation and you kind of brought it to life in that first episode, which is, I think there's a lot of investors that are frustrated because they've been trying to do the right thing and they're tired of getting screwed over, passed over, feeling like they made a wrong decision, which we've been touting for so long. When it comes to investing, that bonds are where your safe money goes, it's where you go to escape, getting out of the stock market when things aren't looking well, until 2022 happens, and then it's super painful. So then, why don't you because this has been a really helpful conversation then depicting the difference between a stock mutual fund and a bond mutual fund, understanding that bond funds are made up of contracts, which is very different from owning a company? Why don't you then bring us home to this last conversation, then talking about flows?

Speaker 2: 21:53

So this is the way that I try to explain this to people is like so you go out and let's just kind of just stick on index funds for a minute, because that seems to be the bigger argument with people is this idea that I'm just going to buy the cheapest funds out there and they'll take care of me and I'll be fine. And then they get absolutely annihilated and they don't know why. And then they say, well, bond funds are just bad. Well, you know, there's a whole library of different types of bonds, the bond market's way bigger than the stock market. So it's not bond funds or bad, it's that you don't understand how they work. Because what happened was you go out and you buy a bond fund, let's say a couple years ago, and let's say, because of where interest rates were and everything, you were buying bonds at a discount. So if we were to forensically audit that fund, we would look at the mutual fund and we say you know, on average, every bond in that fund is selling at a 5% discount, meaning if you hold the bond until it matures, you get an extra 5% of capital appreciation plus the on average 3% interest that they all pay. So you're realizing those returns as the fund kind of chugs along and let's say that the total return ends up coming out to about 6% a year, year over year. And you go this is great, I'm making 6% a year. Now the interest that's being paid out on those bonds are only like 3%. But you're actually also getting this extra money when these bonds are maturing because they're paying. You know they're buying them for cheaper. So then other people look at that and go, wow, you're making 6% on your safe money. I want some of that. I'm making 0% of my savings account, so I'm going to take my safe money and I'm going to put it in the fund that you got, that bond fund that's supposed to be safe. That's making 6%.

Speaker 2: 23:38

Well, now, all of a sudden you've given money to the mutual fund, and the mutual fund in this case is an index fund. They are required to take your money and go and buy bonds. They can't say, no, they can't buy something else, they can't stick it in cash. You give them money, they buy one of everything, period. You know they stick to that mandate. That's what they have to do. So they don't call you up and they don't say hey, look, man, interest rates have changed. If we're gonna buy, you know, for every bond we're buying now it's gonna cost, you know, a thousand five. You know, like we don't wanna buy bonds right now. You know it's not good. They say thank you very much. You're giving us the money. We charge a fee on that. We go and buy what you told us to buy. It's your job to know that you should or shouldn't be buying this, not our job to tell you. So the mutual fund goes out and buys the bonds. Well, so now that person's overpaid. They've locked in maybe some losses, you know, in the future, because those bonds are gonna be maturing, they're not gonna get the same amount of money back. So now, what was averaging 6% maybe is gonna start averaging 3% or something like that. Those interest rates are gonna. You know the total year is gonna start coming down.

Speaker 2: 24:50

The problem with this is the first guy who was in the very first. You were in first, steve, and you had put your money and you made 6%. You own a pro-rata portion of every single investment in that portfolio that's bought and sold and it's in proportion to the total amount of money in the fund that belongs to you. So if it's a billion dollar fund and you get a million bucks in it. You get that much of the actual performance. It all comes to you as a percentage off of every single investment. So you wouldn't have put more money into that bond fund because of course you understand that the bond fund was going to have to buy overpriced bonds and you don't want it to do that. But the other person doesn't. The other person comes in and says take my money, and the bond fund says thank you very much, I'm gonna go buy bonds, I'm gonna overpay for them. First guy, you still own a percentage of all those new purchases. So now your portfolio, which was pretty well priced, you had done a pretty good job Now you want a bunch of stuff that you otherwise don't wanna own, but you're forced to own because other people wanted a piece of what you got.

Speaker 2: 26:01

And then what happens? Then interest rates go up and the resell price is crash. So we had been paying up to 15% more than things were worth to get them because we didn't realize we were doing it, and rates go up. And now the resell price is crash because people start selling them off or they won't buy them right or whatever. Whatever it's driving the price down. And so now the return on your bond fund crashes.

Speaker 2: 26:28

And then that same person who said well, I thought this was supposed to be safe money, you were making 6% of your safe money, I must have got hosed. They go and they say mutual fund, give me my money back. So mutual fund was forced to pay premium maybe you know $1,015 on the dollar to buy something because somebody shoved their money in it not knowing what they were doing. And then that same person said give me my money back. This is a death trap. I'm gonna lose all my money. I need to go back to the savings guy. I'm gonna take my losses now. I'm not gonna send good money after bad right, because this is how irrational we are. And they go, and because the market's volatile, now they're taking 85 cents on the dollar to get their money back out, and this is an exaggeration. If you're doing the numbers at home, I'm sure that they're not gonna line up perfect, but it gives you an idea of how this is actually working and what happens.

Speaker 2: 27:19

Steve, you were the first one in the fund. You're still in the fund. You were forced to own investments that were overpriced and then you were forced to sell investments that were underpriced. Your performance is taking an absolute pounding because of what other people are doing, not because you're interested in that or not. And the problem and this is the last problem with the mutual funds, because you could say, well, as long as you hold them long enough, it irons itself out. Well, if I forced the fund to sell off bonds, it doesn't have a chance to iron it out. And the other thing is the mutual funds are these ongoing portfolios. They're rolling, stuff's coming off and stuff's going on in the books every single day.

Speaker 2: 28:03

If you had a bond portfolio where you went out and you read every contract and you know exactly what you were buying, there's certain things that you would sell at certain times and certain things that you wouldn't, because you'd be like I'm not selling that contract, I'm gonna get killed. I'll sell that one over there, somebody's paying me extra for it. Different than a stock, right? A stock, we talk about price to value and trade and that's a little bit more theory right, where's the price? Or where's the value compared to the price? With a bond, you actually know exactly where the value is and you can easily assess where the price is If you had the choice to say look, I don't wanna sell any of this stuff right now, just sit on it. Or you know what? I got cash but I'm not buying any of these things right now because they're all way overpriced. But when you're in your mutual fund you can't do that because you're on the same ride everybody else is on and you're more so impacted by what all the other fools around you are doing.

Speaker 1: 28:57

I think that's such a great point to bring this episode to a close because, again, I think it's there's benefits to the mutual funds, but also understanding, maybe, the limitations and what you just described as such a big one, because the human element and everything involved done, when you need money and an emergency that no one planned for, you're at the detriment of whatever's happening in that fund and it's really caused from other investors that are getting in and out on the flows of it.

Speaker 1: 29:21

So I think, again, as we've done episodes in the past around investing, and we bring these things to light, if anything, what we hope it does is it empowers you to go back and look at what you've been doing. Go back if you've been in mutual funds and bonds over the years, look at 2022, some of the things we're pointing out and see if any of this lines up with what we've been saying, because I think then the big question is gonna be are I? Travis, you've got me interested. Third part of every series is always should you, should you own bonds? So don't miss this third part of the episode, as we've been laying up to this piece to give you information again that can hopefully inspire you to go get the most from your money in life.