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Morningstar.com's Interactive Classroom

Course 307
Bond Funds, Part 1

Introduction

Glazed eyes. Gaping mouths.

Bond talk is generally considered a sure-fire way to put your dinner companions to sleep. We're convinced that this is largely because people don't really understand the basics of bonds and like everyone—yes, everyone, including the media and a lot of so-called market "experts"—they're terrified by the fixed-income world.

In the next two lessons, we'll quell that terror, detailing all you need to know before choosing your first—and perhaps only—bond fund.

What Bonds Are

If you're going to choose a bond fund, the harsh truth is that you need to know what a bond is. When you buy a stock, you become part owner of the company. When you buy a bond, you are making a loan; you are simply lending money to the company (or, in the case of Treasury bonds, to the government). Your loan lasts a certain period of time—until the date that the bond reaches maturity. In the meantime, you can typically expect dividend payments (commonly known as coupons) as interest on the loan. Thus, the essential issues for bond investing will be the bond's maturity, how much interest it pays, and how confident you are that the business or government can actually repay the loan.

Understand Interest-Rate Risk

Bond prices move in the opposite direction of interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. To determine how dramatic a fund's ups and downs might be, check out its duration.

Duration—or interest-rate risk—boils down to the three risk factors of bonds: maturity, the cash flows from coupons, and current interest rates. Sound confusing? Think of a bond as a pro-basketball player's contract. In negotiating his first contract, a top draft pick wants a salary that will stay competitive with what's offered in the NBA. Looking at different contract proposals, he'll consider the length of a contract (its maturity), the salary (the coupons or cash flow), and wages across the league (current interest rates).

Suppose the player is offered an average five-year contract at $1 million a year. He likes the cash flow, but he's nervous about the long-term commitment. If he takes the five-year contract and the average NBA salary spikes up, he'll be earning a lower salary than average in the last years of the deal, and a lower salary is more likely to become noncompetitive than a higher one. Duration expresses these trade-offs as a kind of risk measure that investors can use for comparison purposes.

One of the nonintuitive aspects of duration is that it's expressed in years, just like maturity. But duration isn't nearly as concrete a concept as maturity. Take a bond with a maturity of 11 years and a duration of 8.5 years. At the end of 11 years, we know that something happens—the bond is paid off. But what happens after 8.5 years? Nothing, really.

Duration is a useful abstraction, though. The higher a bond's duration, the more it responds to changes in interest rates. If a bond fund has a duration of five years, you can expect it to gain 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. And that bond fund with a duration of 8.5 years? We know it's more volatile, and more vulnerable to interest-rate changes, than the bond fund with a duration of five years.

At Morningstar, we're fans of funds with short- and intermediate-term durations—between three and five years. They're just less volatile than longer-duration funds and offer nearly as much return. For example, over the trailing 15 years through May 2011, Vanguard Intermediate-Term Bond Index VBIIX returned 6.89% on average per year, while Vanguard Long-Term Bond Index VBLTX returned less than a percentage point more, at 7.74%. However, the Intermediate-Term Fund's standard deviation was almost half the Long-Term Fund's.

Understand Credit Risk

Interest-rate risk is but one risk that bond funds face. The other, credit risk, involves the fund's credit quality. Credit quality simply measures the ability of an issuer to repay its debts.

Think of it this way. If your no-good brother-in-law who hasn't held a job in six years wants to borrow $50 from you, you would probably wonder if you'd ever see that $50 again. You'd be far more likely to loan money to your super-responsible kid sister who just needs a little emergency cash. The same dynamic occurs between companies and investors. Investors eagerly loan money to well-established companies that seem likely to repay their debts, but they think twice about loaning to firms without a solid track record or that have fallen on hard times.

Judgments about a firm's ability to pay its debts are encapsulated in a credit rating. Credit-rating firms, such as Moody's and Standard & Poor's, closely examine a firm's financial statements to get an idea of whether a company is closest to being a no-goodnik or a debt-paying good citizen. They then assign a letter grade to the company's debt: AAA indicates the highest credit quality and D indicates the lowest.

So if you hold a bond rated AAA, odds are very good that you'll collect all of your coupons and principal. Indeed, bonds rated AAA, AA, A, and BBB are considered investment-grade, meaning that it's pretty likely the company that issued the bonds will repay its debts. Bonds rated BB, B, CCC, CC, and C are non-investment-grade, or high-yield, bonds. That means there's a good chance that the bond issuer will renege on its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default.

Of course, you probably don't want a bond that may not pay its promised coupons and principal. The main purpose in owning a bond, after all, is getting your hands on its income. So if you're bond shopping, you're not going to pick up a lower-rated bond just for the heck of it. You need some sort of incentive. That incentive comes in the form of higher yields. All other things being equal, the lower a bond's credit quality, the higher its yield. That's why you can find a high-yield bond fund with a yield of 7%-8% or more, while many investment-grade bond funds offer yields around 4%. Because investment-grade issuers are more likely to meet their obligations, investors trade higher income for greater certainty.

Credit quality affects more than just a bond's yield, though; it can also affect its value. Specifically, lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession. Recessions usually mean lower corporate profits and thus less money to pay bondholders. If an issuer's ability to repay its debt looks a little shaky in a healthy economy, it will be even more suspect in a recession. High-yield bond funds usually drop in value when investors are worried about the economy.

Quiz 307
There is only one correct answer to each question.

1 If interest rates rise, bond prices:
a. Rise.
b. Fall.
c. Stay the same.
2 Duration measures a bond's:
a. Interest-rate sensitivity.
b. Credit quality.
c. Yield.
3 Which bond fund is taking on the most interest-rate risk?
a. The fund with a five-year duration and an average credit quality of B.
b. The fund with a six-year duration and an average credit quality of A.
c. The fund with a seven-year duration and an average credit quality of AAA.
4 Which bond fund is taking on the most credit risk?
a. The fund with a five-year duration and an average credit quality of B.
b. The fund with a six-year duration and an average credit quality of A.
c. The fund with a seven-year duration and an average credit quality of AAA.
5 High-yield bonds will do poorly when:
a. Interest rates fall.
b. The economy does well.
c. There's a recession.
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