How to Find the Best Core Bond Funds

For the core fixed-income fund holdings in most investors' portfolios, bond funds with short- and intermediate-term durations are the way to go. They're less volatile than longer-duration funds and offer nearly as much return over very long periods of time.

And just as most investors would do well to select bond funds with low to moderate interest-rate sensitivity for their core fixed-income holdings, we'd urge you to take a similarly moderate tack when it comes to credit quality. Although you needn't stick with Treasury-bond funds for the whole of your fixed-income portfolio (the U.S. government is one of the most creditworthy issuers around, but Treasury yields also tend to be lower than any other bond type), we would suggest putting the bulk of your bond portfolio--say, 75% or more--into funds with investment-grade ratings or better.

Morningstar's intermediate-term bond category--which tends to encompass broadly diversified bond funds that don't take on extreme credit-quality or interest-rate risk--is an ideal place to start for most investors looking for a core fixed-income fund. Most of the top-tier bond shops, including PIMCO, Vanguard, Fidelity, Dodge & Cox, and Metropolitan West, have sturdy intermediate-term bond funds as their family flagships.

For investors who are saving for a goal that's close at hand, Morningstar's short-term bond category is a good place to look for core bond exposure. Vanguard and Fidelity both manage topnotch short-term funds that could serve as worthy core holdings for investors seeking to limit interest-rate-related volatility. We'd also recommend that investors--and not just those in the very highest tax brackets--investigate whether municipal-bond funds make sense for their portfolios.

When you're looking for a bond fund, pay special attention to the following pointers.

Look for Low Costs
A penny-pinching mentality is a must when evaluating bond funds. Because bonds typically return less than stocks over the long haul, their costs become a heavier burden.

As if high expenses cutting into your returns weren't bad enough, high-cost bond funds are often riskier than low-cost bond funds. Expenses get deducted from the yield the fund pays to its shareholders, so managers of high-cost funds may do hazardous things to keep their yields competitive with cheaper funds, such as buying longer-duration or lower-quality bonds or taking on leverage. 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 0.75% or less.

Focus on Total Return, Not Yield
If you're looking for income in retirement, it's natural to focus on yield--it tells you something about the size of the checks you'll get when the fund makes its regular income distributions. But chasing yield can have its penalties. Some funds use accounting tricks to prop up their yields while at the same time your principal value, or net asset value, may be declining. Others focus on yield without enough regard for the downside. Higher-yielding but lower-quality bonds can get crunched in recessionary environments, for example. And even though longer-duration bonds typically have higher yields than intermediate- and short-term bonds, they're also more vulnerable to interest-rate changes.

Instead of judging a bond fund by its yield alone, evaluate its total return: its yield plus any capital appreciation (capital appreciation comes from bonds increasing in value if interest rates change) plus compounding of those gains over time. Yield will be the lion's share of a bond fund's return; you just want to be sure that the fund isn't cutting into NAV to produce that yield. Funds with superior long-term returns relative to other funds in their peer group will be your best bet.

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? (Ginnie Mae funds focus on bonds backed by mortgages that the Government National Mortgage Association has guaranteed.) Yet many investors own bond funds that buy only government bonds, or Treasuries, or mortgages. For your core bond exposure, consider intermediate-term, broad-based, high-quality bond funds that hold both government and corporate bonds. You can get higher total returns plus the stability that diversification affords.

Determine if Municipal-Bond Funds Are Right for You
If you're in one of the higher tax brackets, you might consider municipal-bond funds, whose income is exempt from federal income taxes, for the core of your bond portfolio. States, cities, municipalities, and county governments issue municipal bonds, or muni bonds, to raise money. They use the proceeds to improve roads, refurbish schools, or even build sports complexes. The bonds are usually rated by a major rating agency, such as Standard & Poor's or Moody's, based on the quality of the issuer. Unlike income from bonds issued by corporations or the federal government, income from municipal bonds is exempt from federal and often state income taxes if you happen to live in the same state as the state issuing the bond. So when examining a municipal bond's yield, it's important to take the implicit tax advantage into account. Muni bonds usually pay lower rates specifically because of their tax benefits. (Their yields are even higher once you factor in the tax savings.)

You don't need to be in a tax bracket that would allow you to drive a Jaguar or to shop routinely at Neiman Marcus for the tax-protected income from a muni fund to be a good deal for you. That's because income from taxable bonds, unlike dividends or capital gains that you might earn from your stocks or stock funds, is taxable at your ordinary income rate. So if you can save on your bond funds' tax bill by buying munis, your take-home return will be that much higher. Morningstar's Bond Calculator includes a function that lets you compare the aftertax yield on a taxable fund with that of a municipal fund, based on your tax bracket.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Copyright (c) MMV by Morningstar, Inc.

A version of this article appeared Nov. 16, 2011.

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