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Corporate Bond Funds to the Woodshed!

Constant readers will recall a piece I wrote on Municipal bond funds awhile back. (July 21, 2015) Well, now that there's credit turmoil in the corporate world, it's time to take a look at why it pays to build a portfolio of individual bonds instead of using a fund once again.

Last week, a high yield bond fund called Third Avenue Focused Credit had to limit their redemptions because they couldn't get liquid to satisfy client demands for funds. So the investors who didn't bail have no access to their assets, even as values swoon. Another fund, the American High Income Trust, with over $16 billion in assets, has 29% of it's assets in CCC rated paper, and investors are taking notice. And I'm sure Joe and Jane Investor had no idea how much risk they were taking on.

Now, there's nothing implicitly wrong with investing in this paper if you believe the company's credit quality will improve in the future, and the firm's management is getting its house in order. It's no different than buying a stock. Buy low, have a credible reason to believe that the firm will improve its fortunes, and reap the profits. But when you're marketing a fund, you're no longer keeping a leash on risk and reward. You're in a yield sweepstakes, and the one with the highest yield gets the assets, even if it's a fund with paper carrying a 20% yield that will soon default.

Once again, you're riding on someone else's train, and while it is possible to look up what the bond holdings are, the retail investor still, in most cases, would not be able to evaluate the risk involved in each holding. We saw this before in the Franklin and Oppenheimer Municipal Bond Funds, where "state specific" funds were loaded with risky paper from U.S. Territories in order to spike the yield. And unfortunately, when it comes to selling these things, he who has the highest yield “wins,” and that is what most retail investors will be shopping for. When it comes to a bond fund, not only is it impossible to tailor the risk parameters to an individual investor's needs, there are bond issues in these portfolios I've seen that no responsible fixed income pro would dare purchase. But yield sells product.

It is interesting to note how the mutual fund space has been perverted over the years. Mutuals were originally made for people who did not have enough assets to build a portfolio of individual stocks, like General Electric or IBM, and they gave the small investor some needed exposure to asset growth when there were few options available to them beyond bank accounts and U.S. Savings bonds. Then, in the 1980s, a man by the name of Peter Lynch came along, running a fund called Magellan, and in the post-Volcker era of massive interest rate cuts, a giant rush of money came into the markets (plus ça change) and all of sudden, 20% + per annum returns were yours for the asking without even thinking about it. Later, when the fund became so bloated with assets (Lynch saw the fund grow from $18 million to $14 billion, and his successor, Jeffrey Vinik, oversaw $50 billion) it became impossible to manage, and returns suffered. Lynch was no doubt a brilliant manager, but his exit in 1990 was well timed, to be sure. But the die was cast: it was now acceptable as an investment practice to place upwards of $50,000 to $500,000 or even more in a single mutual fund, whereas before, it was a vehicle for a working class person who needed professional investment at a modest cost. Today, there are far more stock funds than there are individual stocks, and sometimes, in the case of bond funds, there simply is not enough issuance out there to satisfy a mandate, so as assets come in, the fund's mission morphs into something unrecognizable. If I were managing $16 billion in high yield paper and 29% percent of that was rated CCC, I have to believe I would be very hard pressed to find close to $5 billion in bonds of that kind in the market that I would want to take responsibility for. There just isn't enough out there that's going to get to the finish line, and this is for just one fund.

Given the cost structure of most funds today, I am of the opinion that they have run their course as an option for the retail investor. If you have the assets, a structured portfolio tailored to your own needs as to risk, reward and need for liquidity is the way to go, and if you don't, there are always index funds. But the lesson is especially true in the fixed income field. The retail investor is paying way too much for an opaque investment.

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