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Course 406
Using Quirky Bond Funds

Introduction

In other lessons, we talked about using various types of funds that can add value to a portfolio. We covered growth funds and value funds, focused and flexible funds, even sector funds. But let's not forget about bond funds.

We'll talk about more than your grandmother's T-bills here; we'll explore high-yield bond funds, bank-loan funds, and Treasury Inflation Protected bond funds. These funds are designed to stamp out some of the interest-rate or inflation risk that may lurk elsewhere in your portfolio. You can also buy them to pick up some extra return.

High-Yield Bond, or Junk Bond, Funds

If you are looking to expand your bond-fund horizons, high yield may be the first area you've considered. High-yield bonds are often called lower-quality bonds, or junk bonds. No matter the name, these bonds offer much more income than Treasuries or other high-quality corporate bonds. That's because they have more credit risk the risk that their issuers may not be able to make regular income payments or pony up the principal they originally promised to return. In other words, if the economy slows down, or if the companies fall into trouble, they may not be able to pay back the IOU.

Because credit risk, not interest-rate risk, is their Achilles' heel, junk bonds help diversify the interest-rate risk inherent with most high-quality bonds. Remember, funds favoring high-grade bonds with far-off maturities can be pretty volatile, depending on what interest rates do. But because junk bonds pay higher yields and are often denominated in shorter maturities, they aren't as sensitive to interest-rate shifts as higher-quality, longer-duration bonds are. For example, the Federal Reserve continued to increase interest rates in the first half of 2006, hurting longer-term, high-quality bond funds. But the average junk-bond fund, which is far less vulnerable to interest-rate movements, gained more than 10% for the year, affected more by declining defaults and improving corporate profits.

When shopping for a junk-bond fund, examine a fund's credit quality, which appears on our fund reports. Is the fund investing in the upper tiers of junk (say, bonds with credit qualities of BB and B), or is it dipping lower for added yield? Check, too, to see if the fund owns any stock, convertible bonds (bonds that convert to stocks), or bonds from emerging markets. These elements would likely make the fund more volatile. Finally, examine how the fund performed during tough markets for junk-bond funds. That will give you a sense of how risky the fund could be in the future. Those tough markets will be periods when the economy faltered. Junk-bond investors experienced trying periods in 1990 and during the summer of 2002 (when Worldcom's bankruptcy roiled the high-yield market), and in 2008, when high-yield bond funds lost more than 26%!

Keep in mind that high-yield bond funds can be a good supplement to a portfolio already well rounded with Treasuries, corporate bonds, and mortgages, all of which offer high credit quality. But you'll generally want to keep junk to less than one fourth of your bond assets.

Bank-Loan Funds

During periods when investors are concerned about rising interest rates, demand for bank-loan funds tends to spike. As their name makes clear, these funds invest in bank loans. Banks typically make such loans to companies as part of a leveraged buyout deal, and then they sell these loans to institutional investors and mutual funds. The yields on the loans rise and fall along with interest rates, which helps cushion the effect of interest-rate changes on the funds' NAVs.

Though bank-loan funds have limited interest-rate-related risk, they can carry substantial credit risk. (In fact, every bank-loan fund in the Morningstar database lands in the lower left-hand corner of Morningstar's fixed-income style box: low credit quality and short interest-rate sensitivity.) That's because the loans that populate most bank-loan portfolios have been extended to lower-quality borrowers, some of which are distressed and/or operate in cyclical industries.

Secondly, most charge relatively high fees when compared with the average bond fund. Further, some use investment leverage, which boosts gains but also magnifies losses. Leverage is essentially borrowing to invest. Say a fund with $100 million in assets invests those assets in a security returning 10% over a given period. In addition, it borrows another $25 million, which it invests in the same security with the same 10% return. At the end of the period, the fund will have increased in value by $12.5 million (10% of $125 million), representing a 12.5% return on the $100 million of its own assets invested by the fund, greater than the 10% the fund would have earned had it not borrowed the $25 million. However, if the securities the fund holds were to fall by 10% instead of rising by 10%, it would be left with a loss of 12.5% rather than the loss of 10% that an unleveraged fund would have endured.

Though bank-loan funds display less sensitivity to interest-rate shifts than many bond funds, that doesn't mean they can't lose money. In fact, bank-loan funds were the worst performing fixed-income category in 2008, losing a whopping 29.7%. In addition to concerns about borrowers' ability to repay their loans, bank-loan funds also suffered that year because some owners of the loans, especially hedge funds, were forced by redemptions to unload shares at the height of the market panic.

When examining bank-loan funds, be sure you understand the funds' credit profile (Morningstar analysts prefer the more conservative option in the group, watch costs, and be sure you know whether or not the fund uses leverage.

Treasury Inflation-Protected Bond Funds

Treasury Inflation-Protected Securities (or TIPS) are issued by the U.S. government and are designed to offer protection against the ravages of inflation.

Like regular Treasury bonds, TIPS are issued with a face, or par, value of $1,000. And also like regular Treasury bonds, they distribute coupon, or interest, payments that are expressed as an annual percentage rate of the par value. However, unlike regular Treasuries, TIPS promise investors that their principal value will rise in lockstep with the Consumer Price Index. That guarantees investors' principal will keep up with inflation, and because TIPS' coupon payments, which are just the real yield, are still calculated as a percentage of that principal amount, their value can move up with inflation as well.

Although TIPS are perhaps the most direct way that investors can add inflation protection to their portfolios, it is important to understand that TIPS do not directly offer protection from rising interest rates. Interest rates and inflation rates don't have to move in unison, and if rates spike without a corresponding rise in inflation, TIPS can suffer a loss.

Pulling It All Together

Ultimately, the key to bond-fund investing is understanding what your funds can and can't do. A basic high-quality fund can act as a good balance to a stock portfolio, but by its very nature, it shouldn't be expected to outperform stocks over a long period of time. (High-quality bonds offer much more certain returns than stocks, so they don't have to proffer such high returns to attract investors.) And because interest rates almost never stand still, a bond fund shouldn't be expected to turn in positive returns every single year, either. In addition, inflation can quickly eat away at the fixed income payments offered by traditional bonds. That's where bonds with different structures, such as TIPS, or those with some credit sensitivity, such as junk bonds, can prove to be a welcome elixir.

Quiz 406
There is only one correct answer to each question.

1 Which type of fund would not likely offset interest-rate risk elsewhere in your portfolio?
a. High-quality bond fund.
b. High-yield bond fund.
c. Bank-loan fund.
2 Which type of fund should fare best if inflation rises?
a. High-yield bond fund.
b. High-quality bond fund.
c. Treasury Inflation Protected bond fund.
3 Which type of fund does not have much credit risk?
a. High-yield bond fund.
b. Prime-rate fund.
c. Treasury Inflation Protected bond fund.
4 Which type of fund owns senior bank loans, or loans from low-quality companies?
a. High-yield bond fund.
b. Bank-loan fund.
c. Inflation-indexed bond fund.
5 Which type of fund will probably suffer most in an economic slowdown?
a. High-quality corporate bond funds.
b. TIPS funds.
c. High-yield bond funds.
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