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The Keys to Picking a Bond Fund

The Keys to Picking a Bond Fund

If you don't want to have all your assets in the stock market, that means you'll need to consider either cash or bonds for your portfolio. Many people admit that when it comes to investing in bonds, they don't know where to begin to evaluate the alternatives.

We've been in a somewhat unusual situation in the last year where the yield curve has been flat or even inverted. The yield curve shows you the range of yields you can receive depending on the time to maturity of the bond you choose. Typically, you are rewarded with higher yields if you buy bonds with longer maturities. But recently, that has not been the case. There is almost no difference in yields for both short- and long-term bonds. But this situation isn't likely to continue.

Let's spend some time understanding the basics of bonds and bond funds.

Make Sure You?re Buying for the Right Reasons
If you are buying bonds to give your portfolio stability or to help generate income, then your strategy may pay off. If you think you can't lose money in bonds, guess again.

Bonds and interest rates have an inverse relationship. That means the value of your bond will go down when rates go up (and vice versa). If you buy an individual bond at par (par means you buy the bond without a premium or discount) and hold it until maturity, you'll get the face value back plus interest. (Face value is the full value of the bond.) If you hold a bond fund, you can lose principal when interest rates rise.

Or so the theory goes. Be aware that you can also lose money when investing in individual bonds if you pay a premium to buy a bond that many people want. For example, in the last few years investors have wanted shorter-term bonds and have been willing to pay a premium for them. Even if those bonds were held until maturity, the face value plus interest may not cover the full purchase price including the premium.

And even though bond funds lose principal when interest rates go down, they also have the ability to increase yield as they purchase higher-yielding bonds over time. So the loss of principal may be temporary. Higher interest may actually mean that the bond fund could outperform individual bonds depending on the underlying investments; a bond fund also offers diversification, which is harder to obtain when you're buying individual bonds.

Understanding Key Bond Factors
The basic determinants of bond performance are interest-rate sensitivity and credit quality.

Interest-Rate Sensitivity
The horizontal axis of the bond style box shows interest-rate sensitivity as measured by duration (see definition below). Here's how I determine which bond funds are short-, intermediate-, or long-term.

Bond Type Short Intermediate Long
Taxable-bond funds 0-3.5 years 3.5-6 years 6+ years
Tax-exempt bond funds 0-4.5 years 4.5-7 years 7+ years

You can use a bond's duration to get a sense of just how much you may lose (or gain, if interest rates go down). The rule of thumb is that for every 1% change in interest rates, the value of your bond will change by the duration of that fund. For example, if interest rates go up by 1% and the duration of your bond is 5.0, your fund will decrease by about 5%. So, in general, the shorter the bond duration, the less it will be affected by a change in rates.

Credit Quality
High-yield (or ?junk?) bonds yield more, but you are also taking on more risk.

Here's how I sort the credit quality of bond funds.
  • High credit quality: Portfolio's average credit quality is AAA or AA.
  • Medium credit quality: Portfolio's average credit quality is lower than AA but greater than or equal to BBB.
  • Low credit quality: Portfolio's average credit quality is below BBB.
If you do nothing else when you investigate a bond or bond fund, be sure you know its duration and credit quality. They will tell you how risky the fund is, and you can then determine if it's right for your situation.

In general, if you are looking for core bonds, I'd stick to short- to intermediate-term duration and medium or high credit quality. If you have a very short-term goal or know you will need to tap into the money within a year, I'd opt for a money-market account or Certificate of Deposit (CD).

Diversify Your Bond Portfolio
Just as you wouldn't want to have all of your stocks in just one style, you'll also want to diversify your bond portfolio. A well-rounded bond portfolio should have some exposure to most, if not all, of the following bond types.

Government Bonds
Considered the safest bond type, government bonds are backed by the U.S. Treasury. Interest is taxed at the federal level but not by the states.
  • Savings Bonds: Each individual can buy up to $30,000 of EE or I Savings Bonds. Both of these bond types defer paying out interest until the bonds are redeemed, making them a good option if you?re trying to keep income taxes low but not so good if you are trying to generate current income. A portion of I-Bonds? interest adjusts along with inflation rates.
  • Treasury Bonds: The maturity (see definition below) of the security determines what type of Treasury you (or your fund) own. A bill has a maturity of two years or less. A note has a maturity of two to 10 years. A bond has a maturity of more than 10 years. Treasury Inflation-Protected Securities (TIPS) have a fixed interest rate, but investors? principal adjusts along with inflation rates. Because interest paid from TIPS is taxable, it's generally best to hold them in tax-deferred accounts.
Mortgage-Backed Bonds
Although not backed in full by the U.S. Treasury, mortgage bonds backed by agencies are still considered relatively safe. Mortgage bonds are made up of a pool of home mortgages. The biggest risk with these bonds is that mortgage holders will prepay their mortgages, and the bondholders will not get the interest they thought they would. Because these bonds carry prepayment risk, their prices are somewhat lower than Treasury bonds and their interest payments are a little higher. The agencies that issue these bonds include GNMA (Government National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). As interest rates increase and fewer people prepay their mortgages, the duration of mortgage-backed bonds gets longer, which can make them more risky.

Municipal Bonds
Municipal bonds, which are issued by state governments and local municipalities, offer interest payments that are exempt from federal taxes and may also be exempt from state income taxes, depending on where you live. These bonds typically offer lower yields than Treasuries because of their tax benefits. A general rule of thumb is that investors in the 25% tax bracket or higher may receive a higher aftertax yield from munis than they would from taxable bonds.

To help decide between a taxable bond fund and a tax-exempt bond fund, take the taxable fund's yield and multiply it by 1 minus your tax rate. This is the fund's tax-adjusted yield. For instance, if you are in the 25% tax bracket and you are comparing a taxable-bond fund paying 4% with a muni fund paying 3.5%, you?d multiply 4% by (1 - 0.25) and compare that with 3.5%. On an aftertax basis, the fund with the 4% yield would yield only 3%. So in this case, the muni fund offers a higher aftertax interest rate.

Corporate Bonds
Generally considered the riskiest type of domestic bond, bonds issued by corporations, as opposed to government entities, typically offer the highest interest payments. Those bonds with the lowest credit-quality ratings (BB and below) are considered ?junk? bonds.

World Bonds
World bonds aren't for everyone. If you want to diversify beyond the U.S. or if you want to take advantage of currency rates, you may want to give them a look. Emerging-markets bond funds are even riskier.

Key Bond-Fund Terms
Duration: A precise look at a fund's sensitivity to interest rates, factoring in when interest payments are made as well as the final payment. For every 1% change in interest rates, the value of your bond fund will change by the duration of that fund.

Credit Quality: The creditworthiness of the bond issuer, as assessed by outside rating agencies. Government bonds are rated AAA, whereas high-yield, or "junk," bonds are those rated BB and below.

Maturity: The number of years until the par value of a bond is repaid. Whenever you buy a bond, you are buying the promise that the issuer will repay your principal in a certain number of years, as well as the promise that the issuer will pay you interest for the privilege of borrowing your money.

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