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What Type of Bond Funds Do You Need?

Christine Benz discusses which types of bond funds make sense for most investors.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. Investors reviewing the bond-fund landscape may be overwhelmed by choices, especially if they're new to bond investing. Joining me to discuss which types of bond funds make sense for most investors is Morningstar's director of personal finance, Christine Benz.

Christine, thank you for joining us today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, let's start with a really basic question. Why should someone consider owning bond funds in the first place?

Benz: Well, the key reason is that you earn some type of income depending on the bond. And that income is quite stable because the bond issuers are held to deliver that income to people who purchase their bonds. So, it's a stable source of income. Income is not really high. So, when you compare long-term bond returns relative to stocks, it's nothing to write home about. The big advantage from a portfolio standpoint is that bonds are really the stabilizers for your portfolio. So, your equities are going to be more volatile. They'll have periods where they will perform really well. They'll have periods where they'll be in a downswing. The bonds tend to just perform steady as she goes. Especially as you get older, and you get closer to needing your money, you want to care more about that stability. And that's what bonds bring to the table.

Dziubinski: Now, if an investor decides, yes, I want to own bonds, and I want to own them through a bond fund, that investor is going to have a lot of choices. What are some of the things you need to be thinking about?

Benz: Well, I would say the key thing is probably to focus on your time horizon--your proximity to needing the money. So, if you have a very short-term time horizon of like a couple of years--so maybe it's like next year's tuition bill or the property tax bill or something like that--you probably want to keep the money very safe. You'd want to keep it in true cash investments. Cash investments mostly are FDIC-insured. Money market mutual funds are a separate category; they're not. But these investments are all but guaranteed if not guaranteed. So, near-term spending, keep that money in cash.

Then, if you have, say, a two- to three-year time horizon, I think that a short-term bond fund, kind of a core short-term fund that might own a gamut of different bond types from government bonds to some high-quality corporate bonds, maybe some mortgage-backed bonds, that can make sense. 

And then, if you have a slightly longer time horizon, like a time horizon of three to five years, or maybe even a little bit longer than that, I think there you can safely use intermediate-term bonds. Here, again, I would focus on the core intermediate-term bond categories. Morningstar has two--core and core-plus. Either of them, I think, makes sense for spending horizons of three to five years. The core-plus funds generally have a little bit more sort of other exposure. So, their yields are higher, but they might invest in foreign bonds or in higher-yielding corporate bonds. So, they entail a little bit more risk. But those are sort of the core building blocks that I would focus on. I think for many--most--investors, they can be kind of one and done with these bond types; they probably don't need to venture much beyond them.

Dziubinski: Now, one thing you didn't address there were long-term bond funds. Why not?

Benz: Well, certainly, when you look at yields, sometimes they can be more attractive than short- and intermediate-term bond funds. And long-term bonds also look great, especially long-term government bonds, from the standpoint of diversifying equity exposure in a portfolio. So, if you're looking for a single category that looks really good from that perspective, long-term government bonds are excellent. The reason we don't typically recommend them at Morningstar is that they're just really volatile. So, as stand-alone investments, they act kind of equitylike in terms of their behavior. And that's not what most investors own bonds for. Most investors own them for that stabilizer role that we talked about.

Dziubinski: Right. Now, if I'm an investor, I see that I can invest either in taxable-bond funds or municipal-bond funds. What are some things to take into consideration to decide which one would be right for me?

Benz: Well, the key thing to think about is to think about your tax rate, because the thing that's going on with municipal bonds is that their income is free of federal tax typically, and it may also be free of state and local tax if you buy a bond from your home municipality. So, there are tax advantages that come along with municipal bonds. That's why people buy them. But those tax advantages are most beneficial to folks who are in the higher tax brackets. So, here, I think it makes sense to put some math behind your decision about what to do. A key point I would make is if you're talking about investing inside of a tax-deferred rapper, like an IRA, don't worry about municipal bonds. They're not for you. They are for your taxable account. But check your tax rate; use a bond calculator to determine whether you're better off in the municipal bond or in the taxable bond.

Dziubinski: And lastly, when we talk about diversifying our equity exposure in our equity portfolios, we often talk about using international funds as a part of that. What about international-bond funds? Should we be thinking about that when it comes to fixed income?

Benz: I think that they can certainly be a diversifier for a portfolio. From a diversification standpoint, the international-bond funds that provide foreign-currency exposure as well as exposure to bond funds--these are the unhedged foreign bond products--those look really great from a diversification perspective if you're looking to diversify your U.S. bond exposure. The trouble is, similar to long-term bonds, they're really volatile. And that's not what most people want when they're thinking about their bond holdings. If you're looking at adding international exposure to your bond portfolio, my bias would be toward the hedged foreign-bond funds. Sort of a very low-cost hedged product, I think, can make sense to help diversify your U.S. bond exposure. I don't see the category as an essential ingredient. I think for most U.S. investors, building out their short- and intermediate-term bond exposure is probably the key priority.

Dziubinski: Great. Thank you so much for the insights today, Christine. We appreciate it.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in.