Consider these key factors before you go bond-fund shopping.
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By Sue Stevens, CFA, CFP, CPA | 08-31-06 | 06:00 AM | Email Article

Now that the Fed has slowed raising interest rates, it may be time to increase your bond fund holdings. You may also want to consider inching your way out from short-term bonds to intermediate-term bonds. So let's go through a little refresher course of what you need to know as you venture into the bond world.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Make Sure You're Buying for the Right Reasons
If you're buying a bond fund 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. 

Bond values move in the opposite direction of interest rates, so the value of your bond will go down when rates go up (and vice versa). That means you can lose principal in bond funds when interest rates rise. Even if you buy individual bonds and hold them until maturity, you can lose money if you paid a premium for your bond.

Know What Your Bond Fund Owns
In order to save yourself from making costly mistakes, it helps if you thoroughly check up on what a bond fund owns before you buy in. Let's start with the basic determinants of bond performance: interest-rate sensitivity and credit quality. These are the two data points we use to place a bond fund in the Morningstar bond style box.

Interest-Rate Sensitivity
The bond style box's horizontal axis shows a fund's interest-rate sensitivity as measured by duration (see definition below). Here's how Morningstar determines which bond funds it considers 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 portfolio's duration to get a sense of just how much your fund 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 fund will change by the duration of that fund. For example, if interest rates go up by 1% and the duration of your fund 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.

That said, typically bond managers will start to add the higher-paying bonds to their portfolios over time. When that happens, you may see an increase in yield that may partially offset the loss in value.

Credit Quality
The vertical axis of the Morningstar style box shows you the average credit quality for a fund (see definition below). High-yield (or "junk") bond funds yield more, but you are also taking on more risk. The style box can give you a visual cue of just how much credit risk a fund is taking on.

Here's how Morningstar sorts 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 a core bond fund, I'd stick to a fund with a short to intermediate 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.

Diversify Your Bond Portfolio
Just as you wouldn't want to have all of your stocks in just one style, you 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 good 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 less 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 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. Morningstar's Bond Calculator can also help you determine whether you're better off investing in taxable or municipal bonds. Risk-averse investors will want to focus on AAA insured muni-bond funds.

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. For more, see
"World Bond Fund Pros and Cons" and "Our Favorite Emerging-Markets Bond Funds".

You can diversify your bond portfolio by holding some of each of the preceding bond types. For example, if you had $100,000 to invest in bond funds, you might put 20% in  Vanguard Inflation-Protected Securities  (TIPS), 25% in  PIMCO Low Duration  (primarily mortgage-backed and corporate bonds), 20% in  Vanguard Limited-Term Tax-Exempt  (munis), 20% in  Dodge & Cox Income  (government, mortgage-backed, and corporate), 5% in  Vanguard High-Yield Corporate , 5% in  Fidelity New Markets Income  (emerging-markets bond), and 5% in  Loomis Sayles Bond   (multisector bond).

Of course, the right combination of bond funds for you depends on how much risk you want to take on and what your objectives are.

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.

A version of this article appeared May 26, 2005.

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Sue Stevens, CFA, CFP, CPA has a position in the following securities mentioned above: VIPSX VIPSX Find out about Morningstar's editorial policies.
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