Get Under the Hood of Bond Funds

Most of us wouldn't buy a new home just because it looked good from the outside. We would do a thorough walk-through first. We'd examine the furnace, check for a leaky roof, and look for cracks in the foundation.

Mutual fund investing requires the same careful investigation. You need to give a fund more than a surface-level once-over before investing in it. Knowing that the fund has been a good performer in the past isn't enough to warrant risking your money. You need to understand what's inside its portfolio--or how it invests. You must find out what a fund owns to know if it's right for you.

The assets in a fund's portfolio are so important that Morningstar analysts spend a lot of their time on the subject. Our analysts examine fund portfolios, talk with the managers about their strategies in picking those holdings, and check on recent changes to the portfolio. Knowing what a fund owns helps you understand its past behavior, set realistic expectations for what it might do in the future, and figure out how it will work with the other investments you might own.

At the most basic level, a fund can own stocks, bonds, cash (usually money market securities), or a combination of the three. If a fund invests in bonds, it could focus only on those issued by the government and companies with rock-solid finances and a high probability that they'll make good on their debts. Or it could venture into higher-yielding bonds issued by firms with shaky future prospects.

How a manager chooses to invest your money has a big impact on performance. For example, if your manager devotes much of the portfolio to a single volatile area, such as low-quality bonds, your fund may generate high returns at times, but there's also a greater likelihood that you'll lose money at other times.

Understanding the Bond-Fund Style Box
The Morningstar Style Box provides a quick visual summary of a given fund's portfolio, using a nine-box investment-style grid to show you where most of your fund's portfolio is invested. For bond funds, the style box focuses on the two key determinants of bond-fund behavior: a fund's sensitivity to changes in interest rates and the credit quality of the bonds in which it invests. Those two factors form the axes of the bond-fund style box. Once we have determined the interest-rate sensitivity and credit-quality coordinates for a bond fund, we use our nine-square style box grid to show investors--visually--where their fund lands. We update each fund's style-box placement every time we receive new portfolio data from the fund company, so the style box also helps investors keep track of whether a fund has changed its approach.

Whereas the stock style box has a growth/value axis and a small/large axis, the two axes of the bond style box are interest-rate sensitivity (or "duration," which we'll discuss in a moment) and credit quality. Interest rate sensitivity is plotted on the horizontal axis as limited, moderate, and extensive, while credit quality is plotted on the vertical axis as low, medium, and high. We arrive at a bond portfolio's style by measuring the average weighted characteristics of the portfolio. ("Average weighted" means that our calculation gives greater weight to a portfolio's big positions than its small ones.)

Let's discuss interest-rate sensitivity first. Knowing a fund's interest-rate sensitivity helps you determine how much it will react when interest rates go up or down. When interest rates go up, that typically depresses the price of already-existing bonds, particularly those with longer maturities, because investors would rather buy a newer bond with a higher interest payment, or yield, than get locked into a long-term bond that happens to have a lower yield. The reverse happens when interest rates go down. Investors would rather buy an existing bond with a higher yield than they would opt for a new, lower-yielding bond. That demand drives up the price of existing bonds.

To help measure a bond fund's interest-rate sensitivity, we rely on a figure called duration. Duration is a pretty knotty concept; it's defined as the average time it takes a bondholder to receive the interest and the principal payments from a bond. Because it's a measure of time, duration is expressed in years. As a general rule of thumb, every 1-percentage-point change in interest rates will cause a fund to gain or lose the amount of its duration. For example, a bond fund with a duration of 8.0 years could lose roughly 8% of its value if interest rates go up by 1 percentage point. That said, typically bond managers will start to add the higher-paying bonds to their portfolios over time. When that happens, you may see an increase in yield that may partially offset the loss in value.

On a monthly basis Morningstar calculates duration breakpoints based around the three-year effective duration of the Morningstar Core Bond Index, which is a broad investment-grade index that includes government bonds, U.S. corporate bonds, and U.S. mortgage bonds. Based on these calculations, we categorize funds' interest-rate sensitivity as follows:

Limited: To be placed in the limited section of the fixed-income style box, the fund's three-year average effective duration needs to fall under 75% of the three-year average effective duration of the MCBI. For example, if the three-year average of the MCBI is 5.935, limited funds would have a three-year average effective duration < 4.45. These funds have limited sensitivity to interest rate changes.

Moderate: To be placed in the moderate section of the fixed-income style box, the fund's three-year average effective duration needs to fall between 75% and 125% of the three-year average effective duration of the MCBI. For example, if the three-year average of the MCBI is 5.935, moderate funds would have a three-year average effective duration >=4.45 and < 7.42. These funds have moderate sensitivity to interest rate changes.

Extensive: To be placed in the extensive section of the fixed-income style box, the fund's three-year average effective duration needs to fall above 125% of the three-year average effective duration of the MCBI. For example, if the three-year average of the MCBI is 5.935, extensive funds would have a three-year average effective duration >=7.42. These funds have extensive sensitivity to interest rate change.

By using the MCBI as the duration benchmark, Morningstar is allowing the effective duration bands to fluctuate in lock-step with the market, which will minimize market-driven style box changes.

To determine a bond fund's placement on the vertical axis, we examine the average credit quality of the bonds in the portfolio and adjust for the changing rates of default between those grades (default rates increase at an increasing rate as grades get lower). By looking at a bond's credit quality, you can get a sense of how likely it is that a bond's issuer will be able to continue making its interest payments to bondholders--an important consideration if you're looking for regular income, as many bond investors are. 

Based on the following breakpoints, Morningstar maps the calculated average asset weighted letter credit rating on the vertical axis of the style box:

"Low" credit quality: where the asset weighted average credit rating is less than BBB

"Medium" credit quality: where the asset weighted average credit rating is less than AA but greater than or equal to BBB

"High" credit quality: where asset weighted average credit rating is AA and higher

Our bond mutual fund categories also relate to the style-box system. For example, the high-yield bond category--home to so-called "junk-bond funds"--captures most of the funds that land in the low-credit-quality row of the style box. Meanwhile, our "Long Government" category includes all of the funds that buy U.S. Treasury and agency bonds with long durations.

The number of holdings in bond funds tends to have less of an impact on how they behave. All else being equal, however, a bond fund with more holdings is likely to be less volatile than one that is more concentrated in bonds from a smaller number of issuers. A bond fund is apt to be particularly risky if it both delves into lower-quality bonds and concentrates in a short list of holdings. That stands to reason, because the fund's fortunes are dependent on a small group of risky securities. 

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