Bonds and money-market funds
When returns come almost entirely from interest, costs take an even bigger bite.
FinanceBogle ch. 13About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why a bond fund's long-run return comes mainly from interest
- Calculate the share of a bond yield that a fee takes
- Explain the extra risks a bond manager can take to make up for high costs
Common-sense investing: the case for index funds: lesson 11 of 13
- Bogle ch. 1
- The Gotrocks family 4 min
- Bogle ch. 2
- Where stock returns come from 5 min
- Bogle ch. 3
- Owning the whole market 4 min
- Bogle ch. 4
- Costs and the market return 3 min
- Bogle ch. 5
- Fund returns versus investor returns 6 min
- Bogle ch. 6
- Taxes are costs too 5 min
- Bogle ch. 7
- When future returns are lower 5 min
- Bogle ch. 8–9
- Why past winners rarely repeat 5 min
- Bogle ch. 10
- Paying for advice 5 min
- Bogle ch. 11–12
- Costs go on forever 5 min
- Bogle ch. 13
- Bonds and money-market funds 4 min
- Bogle ch. 14–15
- New indexes and ETFs 5 min
- Bogle ch. 16–18
- Graham, the arithmetic, and a plan 5 min
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Pairs with Bogle, The Little Book of Common Sense Investing (2007), chapter 13, "Bond Funds and Money Market Funds"
What it is
A bond is a loan to a government or company: it pays interest and returns the money at a set date (its maturity). A bond fund holds many bonds. A money-market fund holds very short-term, high-quality loans.
Bogle's argument: one thing drives these funds far more than anything else, the level of interest rates, and no manager controls it. In the long run, almost all of a bond fund's return is the interest it earns, after costs. So funds holding similar bonds earn similar returns before costs, and cost decides most of the difference after them.
A manager trying to make up for high costs has two main levers, both of which add risk:
- longer maturities, which usually pay more interest but swing more in price when rates change;
- lower credit quality, which pays more but is likelier to default.
Quick check
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According to Bogle, what explains most of the long-run return of a bond fund?
- Bogle argues managers can add only small amounts, and costs usually eat them
Show answer
The interest it earns, minus its costs. Interest rates set the return; costs decide what's left.
Why it matters
Costs that look small next to a stock return look large next to a bond yield. A 1% yearly fee on a fund yielding 4% takes a quarter of your income. And unlike a stock fund's return, a bond fund's yield leaves little room for a manager to earn the fee back.
Worked example
Bogle's figures for 1996–2006, intermediate-term U.S. taxable bond funds:
| Return a year | Expense ratio | |
|---|---|---|
| Low-cost index fund | 6.79% | 0.18% |
| Average fund | 5.50% | 1.00% |
10,000 grew to about 19,289 in the index fund and about 17,081 in the average fund. Bogle notes the active funds held more government and less corporate debt than the index, so cost wasn't the only difference, but he finds it was the main one.
Now a simple case: a bond fund yields 4% a year before costs.
- With a 0.1% fee you keep 3.9%: the fee takes 2.5% of the yield.
- With a 1% fee you keep 3%: the fee takes 25% of the yield.
- Over 10 years, 10,000 grows to about 14,802 at 4%, but 13,439 at 3%.
Common mistake
Choosing a bond fund for its higher yield without asking why it's higher. A higher yield often means longer bonds or weaker borrowers: more risk, not a better manager. Bogle also warns against sales charges on bond funds: a 5% charge can wipe out a whole year's interest.
Key terms
- bond
- a loan that pays interest and is repaid at maturity
- maturity
- the date a bond is repaid
- yield
- the yearly income from a bond or fund, as a % of its price
- credit quality
- how likely the borrower is to pay; lower quality pays more but risks default
- money-market fund
- a fund of very short-term, high-quality loans
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| bond | a loan that pays interest and is repaid at maturity |
| maturity | the date a bond is repaid |
| yield | the yearly income from a bond or fund, as a % of its price |
| credit quality | how likely the borrower is to pay; lower quality pays more but risks default |
| money-market fund | a fund of very short-term, high-quality loans |
Practice
Work it through
A bond fund's bonds yield 5% a year. The fund charges 0.8% a year.
- 5 − 0.8
- 0.8 ÷ 5 × 100
Quick quiz
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Two bond funds hold very similar bonds. Over the long run, the one that earns more after costs is most likely …
- Similar bonds earn similar interest; costs decide the difference
Show answer
the one with the lower costs. Before costs they earn about the same.
A bond fund shows a much higher yield than similar funds. What should you ask first?
- Higher yield usually comes from more risk
Show answer
Whether it holds longer-dated or lower-quality bonds. Extra yield usually means extra risk.
In short
- Bond and money-market returns come mainly from interest, set by the market.
- Similar funds earn similar returns before costs; costs decide most of the difference after.
- A fee takes a bigger share of a small yield: 1% of a 4% yield is a quarter of it.
- Higher yield usually means more risk: longer maturities or weaker borrowers.
Mastery check
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Check yourself
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What share of a 3% yield does a 0.75% fee take?
Show answer
A quarter (25%).
Name two risks a bond manager can take to raise the yield.
Show answer
Holding longer-dated bonds, and holding lower-quality (riskier) bonds.
Why does Bogle think costs matter even more for bond funds than stock funds?
Show answer
Their returns are smaller and come mostly from interest, so costs take a larger share and managers have little room to make them back.
Further reading
- John C. Bogle, The Little Book of Common Sense Investing (John Wiley & Sons, 2007), chapter 13.
- Investor.gov: Bonds, the U.S. SEC's plain-language guide.
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