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By Christine Benz and Eric Jacobson | 06-06-2012 01:00 PM

Key Focus Points for Bond-Fund Investors

Morningstar's Eric Jacobson on the crucial data points that fixed-income fund investors must keep on their radar and how to interpret them.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Many investors are familiar with how to analyze their equity holdings, but fewer have a comfort level with analyzing their bond holdings. Joining me to discuss some key data points to focus on is Eric Jacobson; he is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Great to be with you Christine.

Benz: Eric, if I am a time-pressed individual, and I'm attempting to make sense of my bond fund or prospective bond fund, what are the key data points that you would urge me to home in on as I look across the data that's available on Morningstar.com?

Jacobson: Well, these will be familiar to any folks that have already done a little bit of a digging on their own, but they are crucial to mention of course. Number one is interest-rate risk. We always look at that as one of the first screens for bond funds, and normally, the easiest and best way to do that is to take a look at what the duration of the fund is. And generally speaking duration is an estimate that you can use to figure out how much your fund will either lose or gain if interest rates move a certain amount. So, for example, if you have a duration of five years, and interest rates move by 1%, you multiply the two together and you figure out that if interest rates rise by 1%, you'd expect the fund to lose 5% and vice versa. If interest rates were to fall 1%, you would expect the fund to rise 5%. It's crucial though that I mention it's an estimate. It works well for some kinds of funds better than others, and depending on how the fund company calculates it that there can be slight differences. So, you might find a period where it doesn't work out exactly, but it's a good tool to help you figure out at least what framework you're in.

Benz: Roughly, Eric, for which fund types is duration most useful, and where should I really discount heavily because it's not going to be a super useful figure for me?

Jacobson: That's a great point. It's going to be most useful for funds that are most like Treasuries. So, in other words, government funds and hopefully even government funds with mortgages, though it's a very difficult thing to calculate, and duration can move around a lot with mortgage funds. But generally speaking [duration is most useful for] really high-quality funds. To some degree with municipals, you can rely on it, but again municipals are not exactly like Treasuries. So, it's not a perfect way to measure it.

Once you get out of that sphere, and you're into something where there is a lot more credit risk, like high yield for example, duration is a lot less meaningful and important at least in terms of telling you what's going to happen when interest rates move. All things being equal, a longer-duration high-yield fund will still be more market-sensitive than a shorter-duration one, but it might not really move much when Treasury yields move.

Benz: So, once I've gotten my arms around that interest-rate sensitivity question, what's my next step in terms of data points to focus on?

Jacobson: Sure. Well, the next big one of course is going to be credit risk, and what we tend to do is look at how a fund is broken down by credit category. Now, you've probably heard a lot of managers talk before about how they don't really trust the rating agencies and they do a lot of their own internal credit work. That's all perhaps true, but you can still look at the third-party ratings that a fund gets, or perhaps doesn't get if you have nonrated holdings, to at least gauge roughly how much credit risk your fund is taking.

It's especially valuable if you're looking for a core fund, and it's supposed to be a relatively high-quality fund. But you notice, for example, that there are a lot of securities, a large percentage, for example, in the BBB sector. Now, that BBB is going to be the lowest of the high-quality sectors. It's almost down to junk level. It doesn't mean you own a junk-bond fund necessarily, but it's a signal to you that this isn't a government fund. It shouldn't be used as a substitute for a government fund. And you need to be aware that it's going be taking on more credit risk than say a fund that has all government securities or say 70% in AA for example.

Benz: Once you've gotten your arms around the key aspects of the Morningstar Fixed-Income Style Box, what would the next data points that one should focus on be?

Jacobson: There a lot of places you can go from here on, but if you're just looking to do sort of a quick hit and figure out what's going on with the fund at the high level, my next thing would be to try and look and see how the fund performed during recent prior crises.

So, for example, what happened to the fund that you're looking at during 2008? In many cases what you'll find is that funds that did really well after the crisis did very poorly during the crisis. That's something you might want to dig into a little further. It may be that the manager has changed. It may be that the fund's strategy has changed since then. We've seen a lot of that happen, of course. But if the fund hasn't changed either of those things, and it says, "This is the kind of risk we take," you don't necessarily have to be thinking, "Oh, we're going to face another 2008," but at least it does help you see what some of the worst-case scenarios are.

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