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Costs and Bond Returns

IN TODAY’S LOW-YIELD world, it’s more crucial than ever to hold down investment costs. Suppose a bond fund charges 1% in annual expenses. If the fund owns bonds yielding 10%, the after-cost yield collected by the fund’s investors would be 9%. That means investors are losing a tenth of their investment income to expenses. But if the fund’s bonds are yielding 3% and the fund charges 1%, investors will collect just 2%, as expenses snag a third of their potential yield.

Moreover, what counts is your return after inflation and taxes. You can fend off taxes by holding your bonds in a retirement account or buying municipal bonds. But inflation is harder to combat—and high expenses, whether they’re charged by a fund or you incur them trading individual bonds, could leave you earning a yield that’s below the inflation rate.

None of this would matter if bond-fund managers or individual investors were skilled enough to earn back their expenses and post market-beating results. But there’s scant evidence of that. Instead, over five-year periods, the top performers in any particular bond-fund category will usually be those funds with the lowest annual expenses.

There’s also a danger that higher-cost funds will prove riskier than their low-cost competitors. Managers of higher-cost funds may be especially aggressive as they strive to overcome their costs and thereby keep up with lower-expense competitors. That extra risk could come back to haunt these fund managers—and their shareholders.

Costs can also be a big issue when buying and selling individual bonds, thanks to the large markups that retail investors often pay. Check out the Market Data page offered by FINRA.org, where you can get details on individual bond issues. If you plan to buy or sell an individual bond in the secondary market, it’s helpful to review recent trade data to see whether you’re being offered a fair price. Better still, if you want to buy individual bonds, consider purchasing new issues and then holding the bonds to maturity.

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