Investors who don't have a large bond portfolioor a sufficient knowledge of bonds should notrisk buying individual bonds. Although you mayhear otherwise, you're most likely better off buyingbond funds. But how do you choose from thethousands of bond funds out there? The following arekey criteria you should use:
•Fund company. Character counts, in individualsand institutions. The character of the parent companyof a bond fund is particularly important because managersof a bond can easily boost current yields toentice investors by cutting corners and playing othergames. These games often end in disaster. When youbuy a bond fund, your primary consideration is safety,not just marginally higher yield. Rely only on companieswith unimpeachable integrity such asVanguard and T. Rowe Price.
•Fund managers. Look for a fund whose managershave long, commendable track records, preferablyat the fund itself. Managing bond funds requiresskill and experience. Ultimately, it's the manager whomakes or breaks a fund.
•Taxable vs tax-exempt bonds. To the extent thatit fits into your overall portfolio design, your firstpreference should be holding taxable bond funds intax-deferred accounts. If you're in a high tax bracketand have to buy bond funds in a taxable account, tax-exemptbond funds may be preferable. Compare after-taxyields to make the decision.
•Holdings. Within taxable bonds, the two maincategories are US Treasuries and corporate bonds.Treasury bond funds do not have any default risk, butthey can have plenty of interest rate risk. For mostpeople, corporate bond funds that hold high-qualitybonds (mostly A or better) are a better choice becausethey provide higher returns with only modestly highercredit risk.
Another important category is mortgage-backedbonds such as Ginnie Mae (ie, US GovernmentNational Mortgage Association). They are more complexthan regular bonds, but in the hands of experiencedfund managers, they're not much different fromcorporate bonds. Consider them if they meet yourduration and credit criteria.
•Duration. The longer the maturity of a bond, thehigher its interest rate risk (ie, the more value it willlose when interest rates go up). A bond's duration is abetter measure of its interest rate risk. It's similar tomaturity, but a little more complex. If a bond fund hasan average duration of, say, 2 years, then it will loseabout 2% of its value for every 1% increase in interestrate. Most funds tell you the average duration oftheir holdings on their Web site or if you call them.
Normally, you should buy funds with around 4years'duration. You may get a little higher yield forhigher duration, but generally that's not enough tojustify the higher interest rate risk. In today's environment,you should keep the duration at 2 years or less.
Always read the fund's description to find out whatmaturity it's supposed to hold and what its current averageduration is. For regular bonds, 3-to 4-year durationcorresponds to around 5-to 6-year maturity. Estimatingthe duration of mortgage-backed bonds is more complex;rely on the fund company for that.
•Yield to maturity. The average yield to maturity(YTM) is a truer measure of a bond fund's expectedreturn over time than its current yield, although thecurrent yield is the one you hear about more often. Afund's YTM and current yield should generally beclose to each other. If they aren't, ask the fund companyfor an explanation.
•Expenses. Because bonds provide relativelymodest returns, the expense ratio of a bond fund isvery important. An expense ratio of over 0.5% is dif-ficult to justify, especially when Vanguard offers excellentfunds with expense ratios around 0.25%.
•Index vs actively managed funds. For bonds, agood actively managed fund has a few advantagesover an equivalent index fund, including the managementof interest rate risk. An index fund will maintainthe same duration under all market conditions andcan become too risky in environments like today's,where interest rates can only go up. A conscientiousmanager of an actively managed fund would lowerrisk by shortening duration now and lengthening itafter interest rates go up.
author of The Only Proven
Road to Investment Success (John Wiley; 2001)
and Financial Modeling Using Excel and VBA
(John Wiley; 2004), currently teaches finance at
the Fordham University Graduate School of
Business and consults with individuals on financial
planning and investment management. He welcomes
questions or comments at email@example.com.