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Personal Finance

Bond-Fund Basics

Consider these key factors before you go bond-fund shopping.

During Morningstar's Future of Fixed Income Week, we'll discuss the basics of finding an appropriate bond stake and selecting topnotch fixed-income funds to fill out that allocation: core taxable-bond funds, municipal-bond funds, and noncore investments such as high yield and bank loans. We'll also put some definition around the current fixed-income environment by discovering where some of our favorite managers are uncovering opportunities and forecasting trouble spots, and discuss how to craft a fixed-income portfolio.

But before we dig into that, we're spending some time on Monday to review the fundamentals of fixed income to give investors a refresher on their choices and the key factors they should keep in mind when kicking the tires of a bond fund.

What Is a Bond?
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 a company (corporate bonds) or to a government (for U.S. investors, this is most commonly the U.S. government). Because U.S. government bonds (also known as Treasuries) are issued and guaranteed by Uncle Sam, they typically offer a modest return with low risk. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return.

Your loan lasts a certain period of time--until the date that the bond reaches maturity, when the principal of a bond is repaid. In the meantime, you can typically expect income 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.

Because of their fixed interest payments and the promise of repayment at maturity, bonds are considered less risky than stocks, though they historically have also returned less than equities. So if you're buying a bond fund to give your portfolio stability or to help generate income, then your strategy may pay off. But if you think you can't lose money in bonds, guess again.

Bonds and Credit Risk
One of the key risks bond investors face involves the bond's credit quality. Credit quality simply measures the ability of an issuer to repay its debts.

Think of it this way: If your ne'er-do-well brother-in-law who's drowning in credit card debt 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 more 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, Standard & Poor's, and Morningstar, closely examine a firm's financial statements to get an idea of whether a company is closer 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. (Moody's uses a slightly different ratings scale than S&P and Morningstar, but the basic framework is the same.)

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 higher 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 5% or much more, while many investment-grade bond funds yield less than half that much. 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.

Bonds and Interest Rates
The other key risk that bond investors face relates to interest rates. Bond prices move in the opposite direction of interest rates. When rates fall (as they have been doing for much of the last three decades), bond prices rise. When rates rise, bond prices fall. Why? Remember that most bonds' interest payments are fixed, but prevailing market interest rates may change. If investors are able to buy a similar bond at a higher interest rate next month, then the market value of the lower-interest bond will decrease (that is, it will need to sell at a discount to its face value in order to attract buyers). When prevailing rates fall, then you could sell a higher-interest bond at a premium to face value.

To determine how dramatic a fund's ups and downs might be in a changing-rate environment, check out its duration. Duration measures a fund's sensitivity to interest rates, factoring in when interest payments are made as well as the final payment. 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 roughly 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. (The manager may be able to offset some of that price depreciation by buying higher-yielding securities, however.) 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.

Bonds and Inflation
For holders of nominal (that is, not inflation-protected) bonds, inflation is a natural enemy, right up there with rising interest rates. If an investment is delivering a fixed payout, inflation will reduce the purchasing power of that payout accordingly. Ever since the financial crisis and market meltdown from 2007 through early 2009, many investors have retreated to cash and bonds, in the view that a small but certain return is preferable to the wild gyrations of stocks. But with cash and bond yields as low as they are, as well as the ever-present possibility of inflation, it's important to remember that the safety of bonds and cash may be illusory, as inflation could gobble up every bit of their meager yields and then some. Only safe investments that have an inflation adjustment, such as Treasury Inflation-Protected Securities, provide direct protection against inflation.

The Big Bond Players
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 at the state and local level.

  • Savings Bonds: Each individual can buy up to $10,000 in I Savings bonds and EE Savings bonds per year; taxpayers can also use their Internal Revenue Service tax refunds to purchase an additional $5,000 in I bonds per year. These bond types defer paying out interest until the bonds are redeemed. A portion of I-Bonds' interest adjusts along with inflation rates.
  • Treasury Bonds: The maturity of the security determines what type of Treasury you (or your fund) own. A Treasury bill has a maturity of one year or less. A note has a maturity of two to 10 years. A bond has a maturity of more than 10 years. TIPS have a fixed interest rate, but investors' principal adjusts along with inflation rates. Because TIPS investors pay taxes on the interest income as well as on the inflation adjustments to their principal, it's best to hold TIPS in tax-deferred accounts.

Mortgage-Backed Bonds
Mortgage bonds are made up of a pool of home mortgages. The agencies that issue these bonds include GNMA (Government National Mortgage Association--a U.S. government agency), Freddie Mac, and Fannie Mae (Freddie and Fannie are government-sponsored enterprises). Private institutions such as banks also issue mortgage-backed securities. A big 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 interest payments are a little higher.

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 and local income taxes, depending on where you live. These bonds typically offer lower yields than Treasuries because of their tax benefits.

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.

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
For diversification beyond the U.S. and exposure to foreign currencies, world bond funds have been attracting investor assets recently. Such funds usually invest the lion's share of assets in bonds issued by foreign governments, but they may also hold bonds issued by foreign corporations. Emerging-markets bond funds have historically been considered even riskier, but they have been gaining a lot of attention recently, too, as their yields are often higher than bonds from U.S. issuers.

A version of this article appeared Nov. 14, 2011.