Do Bond Funds Lose with Large Withdrawals?

An issue that is frequently raised regarding fixed income investing is the difference between investing in individual bonds vs. bond funds.  Is one method preferable over the other?  We believe that investing in bond funds is typically the most advantageous way to invest for several reasons.  Bond funds provide greater diversification, a portfolio can be put together instantly, income can be reinvested immediately, the fund’s characteristics can be more easily maintained, they have high liquidity, and they have reduced transaction costs.

However, proponents of investing in individual bonds hold that bond funds are negatively affected when substantial withdrawals are made from a fund.  If a fund experiences significant negative withdrawals they will not be able to reinvest income and could potentially be forced to sell holdings at a discount to meet withdrawal requests.  In order to protect against these issues bond funds typically keep a small amount of the portfolio in cash.  Also, given their large asset base and maturity diversification, have holdings constantly maturing.  The proceeds from these funds can be used to pay investors withdrawing funds.

The past several months has put this issue to the test.  We have seen substantial draw downs from fixed income funds as interest rates have risen.  Over the second quarter $36.7 billion was withdrawn from fixed income funds.  How have fixed income funds performed?  The most widely held fund in RWM client portfolios is the Vanguard Total Bond Market fund, which has seen heavy withdrawals over the quarter given its intermediate term average maturity.  Over the quarter the fund returned -2.4%.  This was in line with its benchmark, the Barclays Aggregate Bond Index, which returned -2.3%.  In July, when bond markets rebounded slightly, the Vanguard fund was up 0.2%, while the Aggregate Bond benchmark was up 0.1%. 

Compared to separately managed accounts the performance was very much in line as well.  The median performance of the more than 400 separate account managers covered by Morningstar for the second quarter was -2.3%.  Over a period with one of the most significant fund withdrawals in the history of the bond market the fund performed in line with the separately managed accounts holding individual bonds as well as its benchmark.

The Vanguard Total Bond Market Fund, which RWM recommends, saw significant withdrawals over the second quarter, but compared very favorably to the benchmark and other separately managed accounts during a very stressed time.  We believe this provides further proof that investing in fixed income through highly diversified mutual funds remains preferable to individual bond investing.

Index Performance                                      July        YTD    Trailing 1 Yr      

US Stock (Russell 3000)                                   5.48%      20.31%         26.86%       
Foreign Stock (FTSE AW ex US)                     4.35%       4.56%          17.65%       
Total US Bond Mkt. (BarCap Aggregate)        0.14%       -2.31%         -1.91%        
Short US Gov. Bonds (BarCap Gov 1-5 Yr)     0.22%      -0.27%         -0.15%
Municipal Bonds (BarCap 1-10yr Muni)          0.11%       -1.23%          -0.46%
Cash (ML 3Month T-Bill)                                 0.01%       0.05%           0.11%

There is no guarantee that any investment strategy, including those described here, will be successful. Any investment or investment strategy can lose money. Past performance does not guarantee or predict future results. You should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Raffa Wealth Management, LLC. This information was gathered from reliable sources but we cannot guarantee accuracy. Indexes do not reflect the fees associated with actual investments and such fees would reduce the performance illustrated.
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