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Bond Funds: the Basics
How to research and analyze
bond funds
The current
market is driving many investors to look to bonds as an alternative to
stocks.
Corporations
and government agencies borrow money by issuing bonds. You can
participate in the bond market by purchasing individual bonds or via
bond mutual funds. Both methods have their adherents, but bond funds
are more convenient, and are arguably the best approach for investments
totaling less than $100,000.
Interest
Rate Risk
Unlike buying a CD or an individual bond where your principal amount
remains fixed, a bond fund’s share price fluctuates. That’s
because bond prices fluctuate, and a fund’s share price reflects the
value of its holdings.
Generally,
bond prices move opposite to overall interest rates. Higher interest
rates drive bond prices down, and vice versa.
You can see
why with a simple example. Say you bought a newly issued $1,000 bond
paying 6 percent annual interest, which amounts to $60 per-year. Suppose
that subsequent to your purchase the prevailing interest rate increases
and similar bonds now offer 7 percent, or $70 annually. If you wanted to
sell your bond, nobody would pay you $1,000 to get $60 interest when the
going rate is $70. Instead, you’d have to reduce your price to the
point where its $60 interest payment amounts to 7 percent return, in
this case, $858.
The return
you achieve while holding a bond fund is the total of the interest
payments the fund receives, plus the change in the value of its
holdings. Declining interest rates boost returns and rising rates reduce
them. If interest rates rise fast enough, the resulting decline in bond
values could exceed the dividends received and produce negative total
returns. Interest rates generally decline in a recession and rise in a
strong economy.
Control
Bond Fund's Interest Rate Sensitivity
You can control your sensitivity to interest rate changes by paying
attention to each fund’s bond duration, which is the average time to
maturity of its holdings. Bond funds are classified according to
duration. Short-term funds hold bonds maturing within one to four years,
intermediate term between five and ten years, and long-term corresponds
to 10 years or more.
The shorter
the term, the less sensitive a bond fund is to interest rates. Thus
short-term funds are the least sensitive to rate changes, but they
return the lowest yields. Theoretically, long-term funds should show
higher returns than intermediate-term funds, but recent studies report
that over time, intermediate funds do just as well, if not better, than
long-term funds.
Bond
Mutual Fund Types
Bond mutual funds often specialize on a particular bond type such as municipal
bonds, other government bonds, or corporate bonds.
Municipal
bonds are not subject to Federal income taxes. You can also avoid state
taxes if you pick a municipal bond fund with most of its holdings in
your home state.
That can be a
significant advantage. For instance, a 6 percent tax-free yield
corresponds to 9.1 percent taxable if your Federal and state tax rates
are 27 percent and 9.3 percent, respectively. I found that information
using the Bond Market Association’s Tax Free vs. Taxable Yield
Calculator (www.investinginbonds.com).
You can use the calculator to find the numbers particular to your
situation by entering your residence state, taxable income, and filing
status.
Finding Bond Fund Candidates
You can use Morningstar’s free Fund Selector to find bond fund
candidates. Get there from Morningstar’s homepage (www.morningstar.com)
by selecting Funds
and then Fund
Selector under Tools.
Morningstar
offers 15 different selection parameters. Here are the parameters that I
found most useful:
-
Use
the Fund Group dropdown menu to select taxable or municipal bond
funds. I ran two screens, one using each selection.
-
Next
I chose $3,000 minimum initial purchase. If you don’t put a limit
here, you’ll end up with funds requiring million dollar starting
amounts.
-
I
specified no-load funds only. Load funds take as much as 4.75
percent off the top. That’s a substantial hit compared to the five
to eight percent annual return you’re likely to realize.
-
Fund
expense ratios are also important because you get the fund’s gross
returns less expenses. For instance, say a fund’s holdings
returned seven percent over the past 12 months. You would net 6.8
percent if the fund’s expenses totaled 0.2 percent, but you’d
receive only 6 percent its expenses totaled 1 percent of assets. I
specified a 0.5 percent maximum expense ratio because that was the
lowest available selection. Focus on the lowest expense ratios in
each category when you analyze the candidates.
- Morningstar’s
Star rating awards five stars to the funds with the best return vs.
risk history in each category, saving you the work of doing the same
comparison manually. I specified five-star funds only.
Screening
with those parameters turned up 17 taxable and 24 non-taxable (municipal
bonds) candidates.
Research and Analyze Candidates
Print your screen results and research each fund in detail using
Morningstar’s free Quicktake
reports. I don’t have room to list everything you should consider, but
here are a few important items:
Review the
five- and 10-year annualized returns on the Total
Returns report. Naturally you want high returns, but also look at
the calendar year returns, especially 1999. That was a year of rapidly
rising interest rates, and many bond funds showed negative returns. The
1999 returns are indicative of what to expect if a strong economic
recovery forces the Fed to persistently boost interest rates.
Also note the
quarterly returns dating back to 1996 listed near the bottom of the
Total Returns report. That’s a good volatility gauge. Volatility
equates to risk so avoid funds showing excessive swings in quarterly
returns.
The Style Box
Details section of the Portfolio
report shows the average credit quality and average duration of the
fund’s holdings. “AAA” ratings are the safest, and risk-averse
investors should require no less. The longer the average duration, the
more sensitive the fund’s returns to changes in interest rates. Two
years corresponds to short-duration holdings, and five years equates to
intermediate.
Morningstar’s
Bond
Center is a good resource for bond fund investing information. From
there, click on Bond
Squad to access Morningstar’s bond discussion board. The
discussions are high-level and informative.
Prudent
investors diversify their holdings among asset classes. Bonds are just
one asset class, and experts warn against overacting to current
conditions by putting all of your holdings into bonds.
Published 7/28/02 |
