Question

Can you have a passive bond fund?  Explain.

Answer 1

Yes.Investors in bond mutual funds and exchange-traded funds (ETFs) have the choice between two types of portfolios: actively managed funds and passively managed funds.Passively managed funds – also called index funds – invest in a portfolio of bonds designed to match the performance of a particular index, such as the Barclays U.S. Aggregate Bond Index. Index funds simply hold the securities that are in the index, or, in many cases, a representative sample of the index holdings. When the composition of the index changes, so do the fund’s holdings. In this case, the managers of the funds aren’t seeking to produce returns greater than the benchmark – the goal is simply matching its performance.

The passive buy-and-hold investor is typically looking to maximize the income-generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes.In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important. The bond may be originally purchased at a premium or a discount while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur.

On the surface, this may appear to be a lazy style of investing, but in reality, passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.

One of the main reasons for their stability is the fact that passive strategies work best with very high-quality, non-callable bonds like government or investment grade corporate or municipal bonds. These types of bonds are well suited for a buy-and-hold strategy as they minimize the risk associated with changes in the income stream due to embedded options, which are written into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call and put features embedded in a bond allow the issue to act on those options under specified market conditions.