Myth 6 indexing is Only for Equities

Credit Repair Magic

Improve Credit Rating

Get Instant Access

As it turns out, indexing is even more relevant to bonds, real estate investment trusts, and other securities. There are a number of bond funds with modest fees that track well-known U.S. and international indexes. Common sense should tell any investor that keeping fees down is especially important in today's low-interest-rate environment where investors are loading up on bonds. A 1% fee on a bond fund that returns only 5% is a much bigger proportion of return than a 1% fee on an equity fund earning 14%.

Bond funds simply don't vary that much in return within their classes. Funds specializing in high-grade corporate bonds pretty much stick together, as do government-debt bonds and high-yield bonds (junk bonds). Credit rating agencies such as Mergent (formerly Moody's) and Standard & Poor's do a fairly good job on average of rating companies' risk of default. They fail to catch firms such as Enron who are less creditworthy than they seem, but by and large they prove a better bellwether of success than equity analysts' earnings estimates.

This is no surprise since the credit rating agencies have fewer obvious conflicts of interest, as they do not offer investment banking services to the same firms they are rating. Also, their job is made easier by the fact that most bonds are sold by firms with a track record of free cash flow to investors seeking relative safety and generally modest returns. Either the interest payments (sometimes called coupons) are paid or they aren't, so analysis tends to be focused on the margin of safety. Of course, every aspect of the firm's operations and financial results may have a bearing on

Table 9.1 Bond Fund Comparison


Vanguard Fund





Vanguard Intermediate Bond Index





Vanguard Long-Term Bond Index





Vanguard Short-Term Bond Index





Source: Morningstar data as of 4/S0/2002

Source: Morningstar data as of 4/S0/2002

this question, but not to the same extent as with the firm's stock, where wild swings in value can occur with small changes in revenues and earnings growth. Equity analysts are given the harder task of predicting these figures with relative precision.

The facts bear out indexing's strength in bonds, because the historical record offers plenty of evidence to prove the point. A review of active bond fund performance does not show remarkable deviation on average from index bond funds of comparable composition (see Table 9.1).

In light of the preceding discussion, why bother trying to outperform in this sector? Isn't safety what bonds are all about anyway? Active bond funds, like their equity kin, tend to concentrate their bets, so the chance of one bond greatly damaging the portfolio is greater than in a diversified index fund.

Was this article helpful?

0 0
Avoiding Credit Card Disaster

Avoiding Credit Card Disaster

People who struggle with saving money and getting out of debt will find these things in common: They don't know how to stop blaming. They have no idea where their money needs to go! They don't know they need to forget the home equity line. They also don't understand they need to sell some investments. Many more problems untold. Well don't worry, With the strategies that I’m about to let you in on , you will have no problems when it comes to understanding how to get out of credit card debt.

Get My Free Ebook

Post a comment