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Bond Funds: the Basics
How to research and analyze
bond funds
With banks paying next to nothing in terms of interest, this may be a
good time to consider corporate bonds.
As you probably know, corporations issue bonds to raise cash. The bonds
pay dividends corresponding to a specified interest (coupon) rate until
the maturity date.
Mutual Funds vs. Individual Bonds
You can buy individual bonds or you can buy shares in bond mutual funds.
Both methods have advantages. For instance, when you buy an individual
bond, assuming the issuer is still solvent, you are assured of
collecting the bond’s face value when it matures. By contrast, mutual
fund share prices fluctuate with the value of the bonds that they hold,
which move with interest rate changes and other market forces.
Nevertheless, bond mutual funds are easier to buy and many pay monthly
dividends compared to most bonds’ semiannual payouts. Thus, mutual funds
are usually the best approach for smaller investors.
Interest Rate Risk
As mentioned, bond prices move when prevailing interest rates change.
Specifically, rising interest rates drive bond prices down and vice
versa.
A bond’s duration is the time left until it matures. You can minimize
interest rate sensitivity by focusing on funds holding short-duration
bonds, that is, bonds maturing within one to four years.
Why
Changing Interest Rates Move Bond Prices
Say you bought a newly issued $1,000 bond paying 6% 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%, 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% return, in
this case, $858.
Bond Types
Bond funds typically specialize on a particular bond type such as
municipal bonds or corporate bonds. Within the corporate category, funds
typically specialize in either investment grade, or non-investment grade
(junk) bonds.
As you might expect, non-investment grade bonds pay higher dividend
yields than higher-rated bonds. However, high-yield bonds don’t
necessarily equate to high-risk, especially when you’re investing via
mutual funds. That depends on the economic environment and the ability
of the fund manager who is picking the bonds. With the economy in
recovery mode, rising interest rates are a bigger risk than corporate
defaults.
Morningstar Fund Screener
Here’s how you can use Morningstar’s free mutual fund screener to find
funds investing in high-yield corporate bonds suitable for current
conditions.
Get there from Morningstar’s homepage (www.morningstar.com)
by selecting
Funds and then
Fund Screener in the Tools section.
Nuts & Bolts
Start by using the Fund Group dropdown menu to select taxable bond
funds, which excludes municipal bond funds.
Next I used the Minimum Initial Purchase menu to specify $3,000. Other
choices include $1,000, $2,000, and $10, 000. Pick the level best
suiting your needs.
Then, use the Load Funds menu to specify “No-Load Funds Only.” Loads are
sales commissions used to compensate advisors or brokers that help you
pick funds. You don’t need to pay them if you’re picking funds on your
own.
Limit Expenses
Use the Expense Ratio menu to limit ratios to 1% or less, which is
important when picking bond funds. Here’s why. Say two funds hold the
same bonds that are yielding 6%, on average. Since the fund’s expenses
come off the top, you would net 5.5% from a fund with a 0.5% ratio
compared to only 4.5% from a fund with a 1.5% expense ratio.
Best Returns—Lowest-Risk
Morningstar rates funds from one to five stars, where five is best,
based on historical returns vs. volatility (risk). Specify five stars to
limit the field to the funds with the best track records.
Bond Credit Ratings
Morningstar also rates risk separately. The choices are low, below
average, average, above average, and high. Select average to rule out
high-risk funds.
Bond rating agencies rate bonds with combinations of letters such as
AAA, AA, or B, where AAA is the safest. Ratings A, AA, AAA, and BBB
signal investment quality, and BB, B, or C are non-investment quality.
Select Average Credit Quality Below BBB to list funds specializing in
high yield (non-investment quality) bonds.
Finally, use the Duration menu to Select Less than Five Years to help
minimize interest rate risk.
Checking Fund Details
My screen listed nine funds. Click on each fund name to see an overview
report listing its expense ratio, current dividend yield, average
duration of bond holdings (effective duration), recent dividend payouts
and much more. In general, lower is better for both expense ratios and
average durations.
Morningstar’s screener often lists funds that aren’t available via
online brokers. Select the Purchase menu to see if the fund is available
from your broker.
The Final List
Only three of the nine funds listed by the screener were generally
available through online brokers. All pay monthly dividends.
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Artrio
Global High Income A (BJBHX): Current dividend yield 6.7%, average
duration 2.5 years, expense ratio 1.0%.
-
Neuberger Berman High Income Bond (NHINX): Yield 8.7%, duration 4.3
years, expense ratio 1.0%.
-
T.
Rowe Price High-Yield (PRHYX): Yield 7.4%, duration 3.3 years,
expense ratio 0.8%.
I don’t have room to tell you everything you need to know about
high-yield bond funds here. Check out Morningstar’s Bond Squad
discussion forum (under Investing Ideas) for surprising informed views
from other investors’ on the topic.
published 4/11/10 |
