At Neighborly, we often hear objections to our core premise — to invest directly in the places and civic projects you care about — from individuals who identify as financially savvy.
We often hear “don’t buy bonds, invest in a bond fund.” We hear this advice from supposedly sophisticated investors all the time. You may likely have investments in funds already, and so the thought of more of the same probably sounds just fine.
But while a bond fund might give you more of the same volatile returns you’ve come to expect from the stock market, at Neighborly we believe they’re not the way to invest in your community and have real impact. Here are four reasons why we’re offering individual bond investments, and not bond funds.
This opinion is usually asserted as if it’s common knowledge. But is it true? And where did it come from?
As with a great many such canned financial advice quips, “buy bond funds instead of bonds” traces its origins back to investment bankers, some of whom earn higher income (some MUCH higher) by influencing where you, the individual investor, deploy your hard-earned savings.
And wouldn’t you know it? Investment bankers can make more money from you with bond funds than with individual bonds.
Wait, what? But the fund fee says very clearly that it’s .68% annually. That’s not so bad, right?
That brings us to the first funny fact about municipal bond funds:
1. Your returns are MUCH lower than Fund Returns – Stated Fund Fees
The stated fees for the fund? Those are just for the fund. They do not include fees paid for holdings inside the fund. And in the world of municipal bonds, such hidden fees can represent a very large percentage of your returns.
Bonds purchased for use in bond funds can change hands as many as 8 times before landing in the fund, through a hidden, extractive process known as flipping. Or “interpositioning,” if you speak bank. At each trade, the holding party tacks on a few additional basis points even if they only hold it for a few minutes. For their troubles, of course. Such fees can add up.
And you’ll never know it. Because muni bond funds often contain a thousand or more holdings. It’s hard enough to understand the trade history of a single bond, let alone a thousand.
Worse, the bonds in your bond fund might even be altered in ways that extract more value from your returns. They could be turned in to derivatives and then sold into the fund, with the creators pocketing an even greater share of the overall returns. You’d need to be a financial wizard and have loads of time on your hands to know for sure.
2. You probably don’t morally agree with everything you’re investing in.
When you invest in stocks, you implicitly support the mission of the company. Same with bonds: you’re voting with your dollars for the project those bonds will fund.
It’s easy to decide which companies and projects to support when you buy individual stocks and bonds, but the way funds currently work, you have no control over what you’re supporting.
You might be surprised to learn that your municipal bond fund invests in things such as:
- carbon-emitting, coal-fired power plants
- privately operated prisons
- inhumane animal shelters
- demolishing historic buildings
And more. But without reading a thousand prospectuses before you invest in the fund, and monitoring the fund as it purchases additional bonds, you’ll never know.
3. You’re probably not getting anywhere near the tax advantage you should be.
One unique characteristic of most municipal bonds is the tax-exempt nature of income generated from them. For all tax-exempt bonds, you pay no federal income tax on income. In most cases, you also pay no state tax as well. For instance, if you live in New York and buy New York municipal bonds, you enjoy a greater tax advantage than if you live in Ohio and buy the same New York bonds.
But in municipal bond funds, often the tax exemption is unoptimized for you. In other cases, the state tax exemption may only apply to those holdings originating from the state(s) in which you pay tax. So if you live in New York and buy a municipal fund that’s over-indexed on California, you’re not making the most of your investment.
In other municipal bond funds, sometimes the tax exemption isn’t even passed through to you at all: it may be withheld and applied to wealthier clients, or institutional buyers.
4. You’re paying to de-risk an already low risk asset.
Detroit. Stockton. Municipal bond defaults happen all the time, right?
Wrong. Those are headlines. Anomalies make the best headlines. As a class, municipal bonds are much safer than just about every other type of security. AAA corporate bonds default more than BBB corporate bonds, for example.
The concept of reducing default risk by investing in funds that “don’t put all your eggs in one basket” is solid when it comes to stock funds, even corporate bond funds. But the price you pay to de-risk municipal bond default — the fund’s fee AND the layers of hidden fees priced in to the fund’s holdings — isn’t worth as much when it comes to municipal bonds, which are by their nature among the lowest defaulting investments around.
As with anything and everything, all things in moderation. Municipal bond funds are part of a well balanced portfolio. But so are individual bonds, and you’ll benefit more from supporting the places and civic projects you care about directly, both in financial and peace of mind terms.