Why Do Funds Make Stocks Safer, But Bonds Riskier?

March 16th, 2010

Suppose you had $100,000 to invest in the stock market. How would you go about it?

Stock Investing: Diversification is the Name of the Game

For decades, the orthodox advice to average investors has been to put the money in one or more mutual funds. And sound advice it is, too. Putting the money in the stock of any one company – no matter how sound, no matter how “hot,” no matter how currently profitable – would be the wrong thing to do. Any information affecting the company’s future stock price is already reflected in its price, which means that changes in that price cannot be predicted. Historical experience tells us that companies do not continue to earn above-average profits ad infinitum; competition eventually erodes them. Thus, putting all 100,000 eggs in one company basket would be a grave error.

That’s where equity mutual funds come in. A $100,000 investment in a mutual fund would automatically be distributed among the shares of many companies – typically, over 100. The risk of loss to principal is spread over so many companies that losses suffered by a few of them are virtually certain to be offset by gains of the rest. Only a marketwide decline (which would also affect a single company in our alternative scenario) can seriously harm the investor. Technological improvement guarantees that productivity will increase over time, and these gains will certainly be reflected in the wide selection of firms held by the fund. In the long run, those productivity gains are what the mutual-fund investor is buying – without the risk of disaster incurred by holding all the money in shares of a single firm.

Another alternative may occur to you. The mutual-fund company incurs expenses in providing its services to you – hiring talent to research and manage the investments of the fund, employing staff to keep books, service customers and handle tax details. You are paying those expenses in the annual fee charged by the fund. Why not do your own diversifying – pick the companies yourself and create your own private fund, saving the expenses of contracting the job out?

The inherent purpose of a mutual fund is diversification – not, as most people suppose, the choice of “winners” in which to invest. (Competition forces different fund managers to pick the best-performing companies.) Deciding how many companies to buy, as well as which ones, takes considerable expertise. It is not inherently impossible for a non-professional to do it, just very unlikely that the amateur would have the time and talent to match the professional’s efforts. Various intricacies, vagaries and regulations of modern-day finance reinforce this point.

Bond Investing: A Different Ballgame

Backtrack to our initial situation. Suppose you had $100,000 to allocate to fixed-income investment. By the same logic just expounded, you should buy shares in a bond fund rather than purchasing a single bond, relying on the expertise of fund managers to select a sufficiently large number of fixed-income securities to provide safety.

Right? No, wrong.

The differences between stocks and bonds turn the logic of the case around almost 180 degrees. In both cases, the benefits to the holder result from a stream of future benefits. With a stock, the benefits flow from the dividend payments to the owner, plus the share-price appreciation. With a bond, the benefits flow from the coupon payments.

Stock dividends and price appreciation are not known with certainty. Indeed, some dividends may be skipped, and the price might even decline. In contrast, bond coupon payments are stipulated in the bond indenture, the contract that governs the bond issue. The bond’s effective yield to maturity fluctuates with changes in its price, which in turn fluctuates inversely with changes in market interest rates. When market interest rates rise, the price of the bond must fall in order for its effective yield to remain competitive with alternative financial instruments; when interest rates fall, its price rises.

Why Holding Individual Bonds Can Be Safer

A stock investment in one company could fluctuate dramatically in value depending on the random factors that influence stock prices. In fact, the company’s demise could wipe out the investment completely. A bond investor could escape price risk by holding the bond to maturity, at which point the bond returns the investor’s principal. The bond investor could also escape business risk (which is called “default risk” when applied to bonds) by purchasing U.S. Treasury bonds, which have traditionally been considered the “riskless asset” by academic students of finance.

Proper diversification of a stock portfolio eliminates business risk, since the bankruptcy of one or two firms in a diversified portfolio will not collapse its value. It also reduces price risk; only a marketwide decline in securities prices will put a sizable dent in the portfolio’s value. (The academic term for this risk, which cannot be eliminated by diversification, is systemic risk.) Thus, the mutual fund performs a valuable service to small investors by aggregating their funds and diversifying the resulting portfolio.

It is true that aggregating bond investments into fund form does diversify the investment and minimize the importance of one or two defaults across the assets of the fund. However, there is another protection against default for bond investor that predates bond funds by many years. Ratings of bond issues by agencies such as Moody’s allow investors to select high-quality investment-grade corporate bonds or municipal bonds.

Meanwhile, another protection afforded by the purchase of individual bonds has been lost in the transition to a bond fund. The investor cannot escape price risk by holding the bond fund assets “to maturity,” because there is no maturity for bond-fund shares. (The fund holds bonds of varying maturities rather than one single maturity.)  Because bond prices fluctuate inversely with market interest rates, the value of fund assets goes up and down as interest rates fluctuate. Not surprisingly, this is referred to as interest-rate risk. Bond funds are actually riskier when compared to individual bonds than are equity mutual funds compared to individual stocks.

The interest-rate risk of holding bonds applies to individual bonds as well as to bond funds; the difference is that holding to maturity eliminates it for single bonds. The longer the term to maturity, the greater are the price fluctuations associated with a given change in interest rates. The quantitative degree of price fluctuation associated with a given change in interest rates is measured by the duration of a bond or a bond fund. Although the word suggests that duration reflects only term structure, it actually embodies coupon-payment and interest information as well. It is an elasticity – measuring the responsiveness of one variable to a change in the other. Bond funds are required to disclose the duration of the fund. This allows the investor to gauge the degree of interest-rate risk borne by holders of the fund.

The Effect of the Financial Crisis on Relative Bond Risk

The traditional status of bond funds relative to single bonds is among many longtime relationships that have been modified by the current financial crisis. On the one hand, the artificially-low interest rates maintained by recent Federal Reserve policy are certain to rise at some point – this increases the risk associated with bond funds. On the other hand, the status of U.S. Treasury bonds – the proverbial “riskless asset” – has also changed. For the first time in living memory, these bonds cannot be viewed as free of default risk. Dramatic increases in federal-government spending have created a tremendous increase in claims on future U.S. income. This has created doubt about the certainty of redemption and interest payments. That has made individual bonds more risky relative to bond funds, since the “hold-to-maturity” strategy is now not ironclad.

Another factor tending to increase the risk of individual bonds is the purported decline in the performance of rating agencies, which – if genuine – makes individual bonds more risky relative to bond funds.

Despite the change in the relative risk of individual bonds and bond funds, the technical differences between equity mutual funds and bond funds still apply.

Category: Economic Analysis, Economic News, Retirement Planning | Tags: , , , ,

Comments are closed.