Bond funds are a poor investment--for anyone.
A bond fund is a collection of bonds but as soon as bonds are placed in a fund, they lose their most attractive characteristics for retirees. The features that make bonds attractive retirement investments are:
1. A known maturity date. You know exactly how long your funds will be working and what date you get your money back
2. A fixed rate of interest so that you have a stable source of retirement income for the entire term of the bond
The moment bonds are placed in a bond fund, there is no longer a fixed maturity date when you will collect the face value (each bond in the fund has a different maturity date) and the interest (called dividends when they come from a fund) will vary. In fact, the interest can ONLY go down as I will explain in a moment. In retirement, the last thing you want to experience is declining income.
Please note that the above retirement information will rarely be explained to you by a financial advisor. In most cases, 80% of financial advisors don't realize what I am explaining here--they simply lack the knowledge and experience. In another 10% of the cases, the advisor understands this but he likes getting the 4% commission he gets when he sells a bond fund rather than the 2% when he sells an individual bond. The remaining 10% of advisors know exactly what I am explaining and will never recommend a bond fund.
The dividends in a bond fund can remain stable during the time you own it or can go down, but not up. Here's why.
If you put yourself in the shoes of the bond fund manager, you see that when interest rates rise (and the shares of the bond fund fall in value), you must sell bonds to raise cash to redeem shares of the people who want to sell their bond fund shares. A lot of Americans sell when the value is falling. That will never change as fear dictates most investment decisions. So when interest rates rise, money is leaving your fund and you do not have any fresh money coming into your fund to buy bonds. The only way to increase the dividend on your fund, is to get fresh money to invest when interest rates are rising. But this will never happen as the shareholders are taking their money out of the fund when interest rates rise.
Investors DO send money to bond funds when interest rates are falling. So as the fund manager, you are forced to put this fresh money to work and buy more and more bonds at lower interest rates and are forced to cut the dividend on your fund.
Now get back in your shoes as the bond fund shareholder. By owning a bond fund, you have no fixed maturity date when you can plan on getting your money back and a dividend that may remain stable or decline. This is a lot worse than owning individual bonds. Bond fund managers and those that sell bond funds however will tell retirees that the fund is better because it gives you diversification and thereby reduces your risk. While this is a good argument if you are buying junk bonds, if you stay with AAA and AA rated bonds, they don't default anyway and you don't need diversification. Yes, it is unfortunate that so many retirement advisors will lead retirees down a path to get financially slaughtered.
In 1998, an obscure article appeared in Time Magazine on this issue:
"The under appreciated irony of bond funds is that while they invest in bonds they don't behave like them. Bond funds cannot guarantee return of principal because, unlike individual bonds they never mature; bond-fund returns, unlike bonds held until maturity, are tied as much to daily price movement as to the interest rate they pay. And the income generated, rather than being fixed, vacillates with market rates. These differences are so fundamental that it's a stretch even to call them bond funds. They're more like a stock. In fact, if you have money in a bond fund, what you really own is common stock in a company that invests in bonds. That stock goes up and down along with the value of the company's assets, which in this case are mostly bonds but sometimes include exotic derivative securities. Clearly, investors seeking to preserve capital and earn a fixed-income stream for a set period of time have no business flirting with such a beast. They should go for individual bonds. Yet bond funds are routinely marketed and accepted as apt substitutes."
If you currently own bond funds, I highly recommend you get out of them. If and when interest rates rise, you will lose value. If instead you own individual bonds, they will also decline in market price but all you need to do is hold your individual bonds and get your face value at maturity. Won't that make your retirement investing a little more comfortable?