What to Look for In a Bond Fund
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.
Select your fund based on its components and their characteristics
It you’re looking for a bond fund that’s going to produce steady returns with little volatility and very limited risk to your principal, start with a bond fund that is built of low-volatility bonds issued by credit-worthy institutions. A perfect example would be a short-term Treasury bond fund. If you’re looking for kick-ass returns in a fixed-income fund, you can start looking 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 fund. But just as with the individual muni bonds themselves, expect lower yield with a muni fund.
Also pick and choose your muni fund based on the level of taxation you’re looking to avoid. State-specific municipal bond funds filled with triple-tax-free bonds (free from federal, state, and local tax) are triple-tax-free themselves.
Prune out the underperforming bond funds
Obviously, you want to look at any prospective bond fund’s performance vis a vis its peers. If you are examining index funds, the driving force behind returns will be the fund’s operating expenses. Intermediate-term Treasury bond index fund X will generally do better than intermediate-term Treasury bond index fund Y if less of the profits are eaten up by operating expenses.
With actively managed funds . . . guess what? Operating expenses are also a driving force. One study conducted by Morningstar, reported in The Wall Street Journal, looked at high quality, taxable bond funds available to all investors with minimums of less than $10,000. More than half of those funds charge investors 1 percent or more.
Not surprisingly, almost three-quarters of those pricier funds showed performance that was in the bottom half of the category for the previous year.
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.
(“Proper and appropriate benchmarks,” refers to bond indexes that most closely match the composition of the bond fund in question. A high-yield bond fund, given that you can expect more volatility, should produce higher yields than, say, a Treasury index. Any comparison of a high-yield fund’s return to a Treasury index is practically moot.)
Never pay a load on a bond fund
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 (that’s called a back-end or deferred load). NEVER PAY A 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. Suppose that the fund manager is a veritable wizard and gets a 7 percent return over the next five years, whereas similar bond funds with similar yearly operating expenses are paying only 6 percent.
Here’s what you’ll have in five years with the load fund, even though there’s a wizard at the helm: $13,254. Here’s what you’d have with the no-load fund, assuming the manager is merely average: $13,382.
Buying a load bond fund is plain and simple dumb. Unless you get some kind of special deal that allows for the load to be waived, don’t buy load funds. Repeat: Don’t buy load funds.
Know how your broker is compensated
Although morally dubious, and in some cases even illegal, some brokerage houses and financial supermarket websites have been known to promote certain bond funds over others not because those funds are any better but because a certain fund company paid to be promoted. (In the industry, this is sometimes known as “buying shelf space.”) Buyer beware!
“Investors need to fully understand how their broker is being compensated, and if a firm is promoting certain bonds or bond funds, investors should ask if the firm is being compensated for that promotion,” says Gerri Walsh, vice president for investor education with the Financial Industry Regulatory Authority (FINRA).