The first rule to follow when choosing a bond fund is to find one appropriate to your particular portfolio needs, which means finding a bond fund made of the right material.
Selecting your fund based on its components and their characteristics
If you're looking for a bond fund that will produce steady returns with very limited risk to your principal, start with a bond fund that is built of low-volatility bonds issued by creditworthy institutions, such as a short-term Treasury bond fund. If you're looking for rockin' returns in a fixed-income fund, look for funds built of high-yield fixed-income securities.
One of the main characteristics you look for in a bond is its tax status. Most bonds are taxable, but municipal bonds are federally tax-free. If you want to laugh off taxes, choose a municipal bond (muni) fund. But just as with the individual muni bonds themselves, expect lower yield with a muni fund. Also pick your muni fund based on the level of taxation you want to avoid. State-specific municipal bond funds filled with triple-tax-free bonds (free from federal, state, and local tax) will be triple-tax-free themselves.
Pruning out the underperformers
Obviously, you want to look at any prospective bond fund's performance vis-à-vis its peers. If you are examining index funds, the driving force behind returns will be the fund's operating expenses.
Operating expenses are also a driving force with actively managed funds. One study conducted by Morningstar looked at high quality, taxable bond funds available to all investors with minimums of less than $10,000. More than half of those funds charged investors 1 percent or more. Not surprisingly, almost three-quarters of those pricier funds performed in the bottom half of the category for 2006.
Don't pay more than 1 percent a year for any bond fund unless you have a great reason. And don't invest in any actively managed bond fund that hasn't outperformed its peers — and any proper and appropriate benchmarks — for at least several years.
Laying down the law on loads
An astonishing number of bond funds charge loads. A load is nothing more than a sales commission, sometimes paid when buying the fund (that's called a front-end load) and sometimes paid when selling (a back-end or deferred load). There is absolutely no reason you should ever pay a load of (not unheard of) 5.5 percent to buy a bond fund. The math simply doesn't work in your favor.
If you pay a 5.5 percent load to buy into a fund with $10,000, you lose $550 up front. You start with an investment of only $9,450. Even if the fund manager is a veritable wizard who gets a 7 percent return over the next five years, whereas similar bond funds with similar operating expenses are paying only 6 percent, you'll have $13,254 in five years with the load fund. With the no-load fund, you'd have $13,382.
Buying a load bond fund is plain and simple dumb. Do not buy load funds.