Less than Zero New World Order

July 20, 2012

We’ve noted the hard times facing lower-risk tolerance investors – times that just got a little bit harder now that the 10-year Treasury bond yield has sunk back below 1.50%. Today, any funds with low interest rate risk (the risk of losing money if rates go up) and low default risk (the risk of borrowers not paying you back) is yielding less than 2%, often much less. 

Between retiring baby boomers and disappointment in a market that seems to slide 50% every few years, there are more lower-risk investors now than ever. But what about the poor multi-trillion dollar mutual fund industrial complex?

If you think trying to get by on 1% or less is tough, imagine trying to squeeze a management fee out of it.

It wasn’t long ago that many money market funds had total expense ratios of 1%. Today, with the types of investments these funds have to buy – short-term government securities and super-duper high quality corporate debt – management fees have taken it on the chin.

Essentially, all money market funds now waive fees. The reason for this is that funds can’t just take the fees out of a money market fund the way they can with stock funds. Doing so would make the fund "break the buck" and price under $1 a share. That's because the yield on the fund holdings doesn’t cover the expense ratio of the fund (which includes the management fee).

Bond funds are fast heading in the same direction. While bond fund prices (Net Asset Values or NAVs) can and do fluctuate, there's a point at which a high-fee bond fund becomes a guaranteed loser. Imagine, if you will, a "short-term investment-grade" bond fund that owns a mix of bonds yielding maybe 1%. If total fees exceed 1%, the yield will essentially be zero with all the (albeit limited) volatility of a bond fund. Better to stick with sub-1% bank CDs.

One example is the Dreyfus Short-Intermediate Government Fund (DSIGX) with a slightly negative current yield of 0.06%. AllianceBernstein Short Duration Portfolio(ADPBX) B class is at negative 0.23% yield and that appears to be after some fee reimbursement.

Naturally, some mutual funds will try to solve this problem by buying riskier higher-yield bonds to push the yield higher than their fees. This is not a good solution for those who want to avoid higher-risk debt. Other ways to get yield up is to buy investment grade long dated adjustable rate debt, often mortgages. This strategy wiped out some funds in the real estate bubble when the mortgage debt wasn’t government backed.

Current Powerfunds Bond Fund Yields

Fund Yield
American Century Core Plus (ACCNX) 1.84%
American Century Government Bond (CPTNX) 1.62%
Vanguard Long-Term Bond Index ETF (BLV) 3.51%
Vanguard Extended Duration Treasury (EDV) 2.65%
Doubleline Total Return Bond (DLTNX) 5.90%
Metropolitan West Total Return (MWTRX) 3.95%


Five Largest Bond Fund Yields (combined assets 1/2 trillion)

Fund Yield
Vanguard Total Bond Market Index (VBLTX) 1.89%
Templeton Global Bond (TGBAX) 3.04%
Vanguard Inflation-Protected Securities (VIPSX) -0.70%
Vanguard GNMA (VFIJX) 2.93%


*Note the largest 5 funds yield for highest asset share class which is often the lowest fee share class and not available to all investors unlike Powerfund bond funds listed above which are readily available to smaller investors. Also note the above yields are “30 day SEC yields” which in some cases can understate the actual ‘distribution’ yield an investor realizes. For more on this check out this WSJ article.

Bad investments often result when your desired investment choices – stocks and bonds – don’t seem to deliver what you need. It's important not to get into even worse options (like commodities) just because yields are currently low on safe investing.

As if this fixed income fee problem weren’t enough, investors are favoring ETFs, big-time. If it weren’t for 401(k)s which primarily use mutual funds and their near-guaranteed place in the retirement of working Americans, the traditional fund business would be in rapid decline. The death of pensions is the lifeblood of the mutual fund industry.

The world’s largest actively managed bond fund company, PIMCO, a fund family we continue to use in our online portfolios and managed accounts, has coined the term "The New Normal" to sum up this world of low-returns. 

PIMCO's trying to lower investor expectations. Bond investors should have their expectations lowered, probably more so than stock investors. When you factor in fees, only the low-expectation investor is going to stick around in mutual funds. The term we’ve come up with is “Less than Zero,” which more accurately describes what you can expect to earn in bond funds, CDs, and other low-risk income investments once you  adjust for fees, taxes, and inflation. 

Bottom line? The expected real return of many fixed income funds is less than zero. Ironically, bond funds have seen the biggest inflows ever in recent years. The five largest bond funds have over $500 billion in combined assets, about the same as the five largest stock funds. Stock funds today still have more money than bond funds, but you have to go back to the early 1990s to find a time where the ratio of money in stock funds to bond funds was this low. Past returns don’t factor in the current bleak situation. In coming issues, we'll discuss options to increase relatively safe returns beyond zero. Sign up to receive FREE email alerts of updated articles here.