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How to Spot a Bad Bond Fund

It's not that hard if you know where to look.

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OK, so "bad" might be a little strong. It's difficult to point to any one or two factors and credibly argue that they alone make a bond fund bad. However, there are red flags that investors can watch for to help ferret out those bond funds that are likely taking on more risk of a blowup than others. The presence of one of these factors might be rightly interpreted as a reason to sit up and pay closer attention. If a bond fund flies multiple red flags, though, chances are that it's best left alone.

My Big Fat Yield
In a cruel irony, tantalizing yields may actually portend trouble. By most definitions, yield is a snapshot of how much income a fund is paying out on an annualized percentage basis, relative to its net assets. The most important axiom to remember, however, is that there is no free lunch. There isn't any extra source of return that  doesn't have some corresponding risk. Sometimes it's as obvious as big-time credit risk; sometimes it's as ephemeral as a dearth of liquidity. But it's always there. And of course, those funds that yield the most often attract a lot of investor attention. Try not to be sucked in. Funds that get into the biggest trouble are often those with the biggest yields. There's a strong correlation between how much yield funds have offered and how poorly they've performed during times of market stress. For example, funds with higher yields at the end of 2007 suffered meaningfully worse than low-yielding funds during the 2008 market meltdown.

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Eric Jacobson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.