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Course 308
Bond Funds, Part 2

Introduction

In Lesson 307: Bond Funds, Part 1 we introduced the two drivers of bond performance: duration and credit quality. In this course, we examine what Morningstar brings to the table: the fixed-income (a common term for bonds because they pay a fixed dividend to bondholders) style box and our tips for smart bond-fund buying.

Morningstar's Fixed-Income Style Box

The fixed-income style box is a nine-square box that gives you a visual snapshot of a fund's credit quality and duration. The style box allows investors to quickly gauge the risk exposure of their bond fund.

The horizontal axis of the fixed-income style box displays a fund's interest-rate sensitivity, as measured by the average duration of all the bonds in its portfolio. Morningstar breaks interest-rate sensitivity into three groups: limited, moderate, and extensive. In previous lessons, we explained that short-term (or limited) bond funds are the least affected by interest-rate movements and thus the least volatile; long-term (extensive) funds are the most volatile. Morningstar divides funds into these buckets based on their duration relative to the 3 year effective duration of our core bond index.

The vertical axis of the style box measures credit quality and is also broken into three groups: high, medium, and low. A fund's placement is determined by the average credit quality of all the bonds in its portfolio, and also adjusts for the fact that default rates increase more rapidly between lower grades than higher grades. Funds with high credit qualities tend to own either U.S. Treasury bonds or corporate bonds whose credit quality is just slightly below that of Treasuries. On the other hand, funds with low credit quality own a lot of high-yield, or junk, bonds. Medium-quality funds fall between the two extremes.

The style box can make it far easier for investors to find appropriate funds. Say you need a fund that carries only slightly more risk than a money market fund. Just look for funds that fall within the short-term, high-quality square of the style box. Or perhaps you want a rich income stream but aren't comfortable buying junk bonds. A fund that falls within the long-term, medium-quality square might be the answer. You can find the style box for all bond funds on their Morningstar Fund Reports.

Our Bond-Fund Buying Advice

Look for low costs.

A Wal-Mart WMT mentality is a must when evaluating funds—even more so when the funds in question buy bonds. Because bonds typically gain less than stocks over time, their costs become a heavier burden. Costs are the most important factor when evaluating bond funds, hands down.

Note that, in addition to their expenses, high-cost bond funds often take on more risk than low-cost bond funds. Expenses get deducted from the income the fund pays to its shareholders, so managers of high-cost funds often do the darndest things to keep yields competitive, such as buying longer-duration or lower-quality bonds, or complex derivatives. In doing so, they increase the fund's risk.

Managers with low expense hurdles, in contrast, can offer the same yields and returns without taking on extra risk. Plenty of terrific bond funds carry expense ratios of 0.60% or less.

Focus on total return, not yield.

Yield provides instant gratification in the form of regular income checks. But chasing yield can have its costs. Some funds use accounting tricks to prop up their yields at the expense of their principal, or net asset value (NAV). Managers will pay more than face value for high-yielding bonds and distribute that entire yield as the bonds depreciate to face value. Or they'll buy undervalued bonds and supplement their lower yields with capital gains. Both practices cut into NAV.

Investors sometimes accept dwindling NAVs for burly yields because they want the regular income that yields offer. Bad idea. Yield is nothing more than a percentage of NAV, so shrinking NAV leads to smaller income checks over time.

Imagine a $10,000 investment in a fund carrying an NAV of $10 and yielding 6.5%. One year later, the fund still yields 6.5%, but its NAV has slipped to $9. In that one year, income dropped from $650 to $585.

So instead of judging a bond fund by its yield, evaluate its total return—its yield plus or minus any capital appreciation or depreciation.

Seek some variety.

You wouldn't choose a fund that buys only health-care stocks as your first equity fund, so why should your first (and perhaps only) bond fund be a narrowly focused Ginnie Mae fund? Yet many investors own bond funds that buy only government bonds, or Treasuries, or mortgages.

For your first—and maybe only—bond fund, consider intermediate-term, broad-based, high-quality bond funds that hold both government and corporate bonds. Those investors in high tax brackets might consider municipal-bond funds, whose income is exempt from income taxes.

Quiz 308
There is only one correct answer to each question.

1 Morningstar's fixed-income style box visually depicts a fund's:
a. Credit quality and duration.
b. Expenses and duration.
c. Total return and credit quality.
2 Bond funds with high expense ratios:
a. Usually return less than bond funds with low expense ratios.
b. Are riskier than bond funds with low expense ratios.
c. Both.
3 Which is likely the better bond fund over the long term?
a. Fund A with a 6% yield and a 5% total return.
b. Fund B with a 5% yield and a 6% total return.
c. Fund C with a 5% yield and a 5% total return.
4 According to Morningstar, which bond fund would be the best choice?
a. Fund A with an expense ratio of 1%, a duration of eight years, and an average credit quality of AAA.
b. Fund B with an expense ratio of 0.75%, a duration of seven years, and an average credit quality of AA.
c. Fund C with an expense ratio of 0.5%, a duration of seven years, and an average credit quality of AA.
5 Which is least important when evaluating bond funds?
a. Their yields.
b. Their total returns.
c. Their expenses.
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