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As this blog has documented over the years, I could be accused of being somewhat enamored with Costco Wholesale Stores.  Generally not a fan of chains, big box stores or even shopping in general, nearly everything about how Costco runs their business, treats their staff, provides good service and generally high quality products to their members really strikes a chord with me as a consumer.  I try and limit my Costco cravings to no more than two trips per month, but when I do, I time my visits with a nearly empty gas tank to take advantage of their very attractive fuel prices.

But, enough of my cheerleading.  I mention all of this because, with gas prices dropping dramatically over the last several months, a recent article in the Wall Street Journal caught my eye.

Cheaper Fuel Pumps Up Costco discusses how falling prices might positively impact Costco’s bottom line as they buy so much fuel that they are able to benefit from falling prices incrementally much faster than much of their competition.

Picture a mom & pop gas franchise across the street from a Costco.  They may fill up their fuel tanks once a week whereas Costco might fill theirs several times per day.  In an environment where prices are falling fast, each fill allows Costco to enjoy either slightly higher margins, offer lower prices or some combination of both.  Meanwhile, the mom & pop station with more expensive fuel in their tanks, has to either match the price drop and lower profit margins, or maintain prices and face fewer customers and less inside sales of candy, soda and other products where they really make their money.

It occurred to me that these market benefits share a lot of similarities with one of the many reasons we choose to use short term, high quality bond funds versus individual bonds in our fixed income portfolios.

Using the Costco gas example, picture a scenario where interest rates begin rising, causing the value of existing, lower yielding bonds to go down.  If you’re sitting on a one, two or five year individual bond and the price goes down, you’re in much the same condition as the mom & pop store.  Either sell the bond at a loss and hopefully make it up in the long run by taking advantage of higher rates or hang onto the bond until maturity to protect your principal, missing the opportunity and tying up cash you might need.

The bond funds, on the other hand, represent Costco.  These funds hold many bonds within their funds, some maturing in a year or two, but others maturing much sooner.  As rates rise, fund managers have cash available from these maturities which allows them to immediately start participating in improving yields.  There are also all kinds of benefits to liquidity, diversification and the like, but those are different arguments for a different day.

We’ve seen very direct evidence of this in bonds this year.  While interest rates remain in flux, we have seen some slope returning to the yield curve in bonds.  Instead of being stuck on individual holdings purchased over the last several years at extremely low rates, we’ve watched as some of the slightly longer term funds have displayed improving returns as they participate in slightly higher rates.

Have a great week!