Bonds Articles

Cheat Sheet / Updated 02-25-2022

If you want to invest in bonds, you need to know how to read the bond ratings that the big three rating companies use and how to figure whether a taxable or tax-free municipal bond is the better investment. Knowing the right questions to ask about a bond can save you money, and you can find answers to many of those questions on the Internet.

Article / Updated 07-06-2021

Here are some examples of investment portfolios based on real, live clients with bond portfolios. Their names have been changed to protect the identities of these good people. Perhaps you will see some similarities between their situations and yours. Jean and Raymond, 61 and 63, financially quite comfortable Married in 1982, Jean and Raymond raised three children; the third is just finishing up college. Jean and Raymond are public school teachers, and both will retire (he in two years, she in four) with healthy traditional pensions. Together, those pensions, combined with Social Security, should cover Jean and Raymond’s living expenses for the rest of their lives. The couple will also likely bring in supplemental income from private tutoring. Jean’s mother is 90. When Mom passes away, Jean, an only child, expects to receive an inheritance of at least $1.5 million. Mom’s money is invested almost entirely in bonds and CDs. So what should Jean and Raymond do with the $710,000 they’ve socked away in their combined 403(b) retirement plans? Jean and Raymond are in the catbird seat. Even if they were to invest the entire $710,000 nest egg in stocks, and even if we were to see the worst stock market crash in history, Jean and Raymond would likely still be okay. The couple certainly doesn’t need to take the risk of putting their money in stocks because they don’t need to see their portfolio grow to accomplish their financial goals. But given their pensions, is investing in stocks really that risky? No. If Jean and Raymond want to leave a large legacy (to their children, grandchildren, or charity), a mostly stock portfolio may be the way to go. Because equities tend to be so much more lucrative than fixed income in the long run, a greater percentage in equities would likely generate more wealth for future generations. Ignoring for the moment a slew of possibly complicating factors from the simple scenario above, they should feel comfortable with an aggressive portfolio: perhaps two-thirds in equity (stocks and such) and one-third in fixed income (bonds and such). It’s not what most people think of as appropriate for an aging couple, but it makes a whole lot of sense, provided Jean and Raymond are fully on board and promise not to cash out of stocks (as many investors do) the first time the market takes a dip. Kay, 59, hoping only for a simple retirement Kay, divorced twice, earns a very modest salary as a medical technician. She scored fairly well in her last divorce. Thanks to a generous initial cash settlement, as well as having made a good profit on the sale of her last home, Kay has a portfolio of $875,000. Kay doesn’t hate her work, but she isn’t crazy about it, either; she would much rather spend her days doing volunteer work with stray animals. After careful analysis, she figures that she can live without her paycheck quite comfortably if she pulls $45,000 a year from savings. Her children are grown and self-sufficient. Kay’s example illustrates why simple formulas (such as your age = your proper bond allocation) don’t work. Kay is roughly the same age as Jean in the previous example. And Kay, like Jean, is financially comfortable. But it would be a big mistake for Kay to take the same risks with her money. Unlike Jean, Kay does not have a spouse. Nor does Kay have a pension. And unlike Jean, Kay is not expecting a big inheritance. Kay can't afford to lose any significant portion of her nest egg. She is dependent on that nest egg to stay economically afloat. At her current level of savings and with a fairly modest rate of growth in her portfolio, Kay should be able to retire comfortably within four to five years. In Kay’s case, she has more to lose than to gain by taking any great risk in the markets. On the other hand, if things work out as she plans, Kay may be spending 30 or more years in retirement. So an all fixed-income portfolio, which could get gobbled up by inflation, won’t work. In Kay’s case, depending on her tolerance for risk, a good recommendation would be a portfolio of 50 to 55 percent stocks and 45 to 50 percent bonds, as shown. Juan, 29, just getting started Three years out of business school with an MBA, Juan, is single and happy in his city condo. And he's earning an impressive and growing salary. But because he has been busy paying off loans, he has just started to build his savings. Juan’s 401(k) has a balance of $3,700. Juan is another example of why simple formulas don't work. He should probably tailor his portfolio to look something like Jean and Raymond’s, despite the obvious differences in age and wealth. Juan is still many years off from retirement and doesn’t see any major expenses on the horizon. His budding 401(k) is meant to sit and grow for a very long time — at least three decades. History tells us that a portfolio made up of mostly stocks will likely provide superior growth. Of course, history is history, and we don’t know what the future will bring. So it would still be a good idea to allocate 20 to 25 percent bonds to Juan’s portfolio. Before moving any money into stocks or bonds, however, Juan would want to set aside three to six months’ worth of living expenses in an emergency cash fund, outside of his 401(k), just in case he should lose his job, have serious health issues, or face some other unforeseen crisis. Miriam, 53, plugging away Never married, with no children, Miriam wants to retire from her job as a freelance computer consultant while still young enough to fulfill her dreams of world travel. Her investments of $75,000 are growing at a good clip, as she is currently socking away a full 20 percent of her after-tax earnings — about $20,000 a year. But she knows that she has a long way to go. Miriam is right; she has a long way to go. To fulfill her dreams of world travel, Miriam needs considerably more than a nest egg of $75,000. In this case, the bond allocation question is a tough one. Miriam needs substantial growth, but she isn’t in a position to risk what she has, either. Cases like Miriam’s require delicate balance. She should most likely opt for a starting portfolio of mostly stocks and about 25 to 30 percent bonds, but as Miriam gets closer to her financial goal in coming years, she could up that percentage of bonds and take a more defensive, conservative position.

Article / Updated 07-01-2021

After suggesting a bond portfolio — or any other kind of portfolio — to a new client, dealers often hear, “But . . . is now a good time to invest in bonds?” The answer is yes. You can’t predict the future of interest rates With stocks, the big concern people have is usually that the market is about to tumble. With bonds, the big concern — especially these days — is that interest rates are going to rise, and any bonds purchased today will wither in value as a result. But interest rates are almost as unpredictable as the stock market. Yes, the government has more control over interest rates than it does the stock market, but it doesn’t have complete control, and the actions it decides to take or not take are not for you to know. And furthermore, even if you could predict interest rates (which you can’t), and even if you did know that they were going to rise (which you don’t), now still is a good time to buy bonds. This is assuming, of course, that you’ve done the proper analysis, and you’ve decided that more bonds belong in your portfolio, and you have cash in hand. What do you do with it? You have three savings/investing options, really: Keep it in cash. Invest it in equities. Invest it in fixed income. If you invest in equities (stocks, real estate, commodities), you mess with your overall portfolio structure, making it perhaps too risky. If you keep cash (a savings or money market account), you earn enough interest to maybe keep up with inflation — but after taxes, probably not. In either scenario, you lose. Now, suppose you choose to go ahead and buy the bonds, and interest rates, as you feared, do rise. That isn’t necessarily a bad thing. Yes, your bonds or bond funds — especially those with long maturities — will take a hit. The value of the bonds or the price of the bond-fund shares will sink. In the long run, though, you shouldn’t suffer, and you may even benefit from higher interest rates. After all, every six months with individual bonds, and every month with most bond funds, you get interest payments, and those interest payments may be reinvested. The higher the interest rate climbs, the more money you can make off those reinvestments. Waiting for interest rates to fall — which they may or may not do — just doesn’t make sense. When interest rates are very low, as they are these days, it makes sense to lean your bond portfolio more toward the short-intermediate side than the long-term. Yes, you’ll get a lesser yield, but you’ll take a softer punch when interest rates do rise. A good aim normally is an average maturity in your bond portfolios of five to seven years. These days, you might accept the lower yield that comes with a bond portfolio with an average maturity of three to five years. Don’t pay too much attention to the yield curve Another difficult decision for bond investors putting in fresh money occurs at those rare times in history when we see an inverted yield curve. The yield curve refers to the difference between interest rates on long-term versus short-term bonds. Normally, long-term bonds pay higher rates of interest. If the yield curve is inverted, that means the long-term bonds are paying lower rates of interest than shorter-term bonds. That situation doesn’t happen often, but it happens. The reasons for the yield curve are many and complex, and they include inflation expectations, feelings about the economy, and foreign demand for U.S. debt. Whatever the reasons for an inverted yield curve, it hardly makes sense to tie up your money in a long-term bond when a shorter-term bond is paying just as much interest or possibly a slight bit more. Or does it? Some financial planners disagree, but it’s not always a bad idea to invest in longer-term bonds even when the yield curve is a slight bit inverted. Remember that a large reason you’re investing in bonds is to have a cushion if your other investments (such as stocks) take a nosedive. When stocks plunge, money tends to flow (and flow fast) into investment-grade bonds, especially Treasuries. Initially, the “rush to safety” creates the most demand for short-term bonds, and their price tends to rise. Over time, however, a plunge in the stock market often results in the feds lowering interest rates (in an attempt to kick-start the economy), which lifts bond prices — especially the price of longer maturity bonds. In other words, long-term Treasuries are your very best hedge against a stock market crash. Consider another reason for investing in longer-term bonds, even if they aren’t paying what short-term bonds are paying. What if interest rates drop, regardless of what’s going on in the stock market? Sometimes interest rates fall even when the stock market is soaring. If that’s the case, once again, you may wish that you were holding long-term bonds. Adhere — or not — to dollar-cost averaging Instead of throwing all your money into a bond portfolio right away, some people say it makes more sense to buy in slowly over a long period of time. As the argument goes, you spread out your risk that way, buying when the market is high and when the market is low. And if you invest equal amounts of money each time, you tend to buy more product (bonds or fund shares) when the market is low, potentially adding to your bottom line. This approach to investing is called dollar-cost averaging. Dollar-cost averaging makes some sense if you are taking freshly earned money and investing it. If you have an existing pool of cash, however, it simply doesn’t make sense. The cash you leave behind will be earning too little for the whole scheme to make any sense. If you have a chunk of money waiting to be invested, and you have an investment plan in place, go for it. Buy those bonds you were planning to buy. There’s no reason to wait for just the right moment or to buy in dribs and drabs.

Article / Updated 06-29-2021

About 98 percent of the approximately $5 trillion in outstanding Treasury debt is made up not of savings bonds but of marketable (tradable) securities known as bills, notes, and bonds. Technically, bills, notes, and bonds are all bonds. They are all backed by the full faith and credit of the U.S. government. They are all issued electronically (you don’t get a fancy piece of paper as you do with savings bonds). They can all be purchased either directly from the Treasury or through a broker. They can all trade like hotcakes. The major difference among them is the time you need to wait to collect your principal: Treasury bills have maturities of a year or less. Treasury notes are issued with maturities from two to ten years. Treasury bonds are long-term investments that have maturities of 10 to 30 years from their issue date. The bills, like savings bonds, are sold at a discount from their face value. You get the full amount when the bill matures. The notes and bonds, on the other hand, are sold at their face value, have a fixed interest rate, and kick off interest payments once every six months. The minimum denomination for all three is $1,000, and you can buy them all in any increment of $1,000. Keep in mind that you don’t have to hold any of these securities (bills, notes, or bonds) till maturity. You can, in fact, cash out at any point. The longer until the maturity of the bond, however, the more its price can fluctuate and, therefore, the more you risk losing money.

Article / Updated 03-16-2021

You can invest in bonds in one of two major ways: You can purchase individual bonds, or you can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund or exchange-traded fund. If you want to take the individual-bond route, that path is covered here, where you learn how to decipher bond listings you find in financial newspapers or online. Also learn about the purchasing process for treasuries (a different animal in that you can buy them directly from the government) and all other bonds. Decide between individual bonds and bond funds Unless the bonds you’re considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you’re generally better off investing in bonds through a mutual fund or exchange-traded fund. Here’s why: Diversification is more difficult with individual bonds. You shouldn’t put your money into a small number of bonds of companies in the same industry or that mature at the same time. It’s difficult to cost-effectively build a diversified bond portfolio with individual issues, unless you have a substantial amount of money ($1 million) that you want to invest in bonds. Individual bonds cost you more money. If you purchase individual bonds through a broker, you’re going to pay a commission. In most cases, the commission cost is hidden—the broker quotes you a price for the bond that includes the commission. Even if you use a discount broker, these fees take a healthy bite out of your investment. The smaller the amount that you invest, the bigger the bite—on a $1,000 bond, the commission fee can equal several percent. Commissions take a smaller bite out of larger bonds—perhaps less than 0.5 percent if you use discount brokers. On the other hand, investing in bonds through a fund is cost-effective. Great bond funds are yours for less than 0.5 percent per year in operating expenses. Selecting good bond funds isn’t hard. You’ve got better things to do with your time. Do you really want to research bonds and go bond shopping? Bonds are boring to most people! And bonds and the companies that stand behind them aren’t that simple to understand. For example, did you know that some bonds can be called before their maturity dates? Companies often call bonds (which means they repay the principal before maturity) to save money if interest rates drop significantly. After you purchase a bond, you need to do the same things that a good bond mutual fund portfolio manager needs to do, such as track the issuer’s creditworthiness and monitor other important financial developments. Understanding bond prices Business-focused publications and websites provide daily bond pricing. You may also call a broker or browse websites to obtain bond prices. The following steps walk you through the bond listing for PhilEl (Philadelphia Electric) shown in the figure below: Bond name: This column tells you who issued the bond. In this case, the issuer is a large utility company, Philadelphia Electric. Funny numbers after the company name: The first part of the numerical sequence here—7-1⁄8—refers to the original interest rate (7.125 percent) that this bond paid when it was issued. This interest rate is known as the coupon rate, which is a percent of the maturity value of the bond. The second part of the numbers—23—refers to the year that the bond matures (2023, in this case). Current yield: Divide the interest paid, 7.125, by the current price per bond, $93, to arrive at the current yield. In this case, it equals (rounded off) 7.7 percent. Volume: Volume indicates the number of bonds that traded on this day. In the case of PhilEl, 15 bonds were traded. Close: This shows the last price at which the bond traded. The last PhilEl bond price is $93. Change: The change indicates how this day’s close compares with the previous day’s close. In the example figure, the bond rose 2-1⁄8 points. Some bonds don’t trade all that often. Notice that some bonds were up and others were down on this particular day. The demand of new buyers and the supply of interested sellers influence the price movement of a given bond. In addition to the direction of overall interest rates, changes in the financial health of the issuing entity that stands behind the bond strongly affect the price of an individual bond. Purchasing treasuries If you want to purchase Treasury bonds, buying them through the Treasury Direct program is the lowest-cost option. Call 800-722-2678 or visit the U.S. Department of Treasury’s website. You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through Treasury Direct requires you to transfer the bonds to a broker. The advantage of a fund that invests in treasuries is that it typically holds treasuries of differing maturities, thus offering diversification. You can generally buy and sell no-load (commission-free) Treasury bond mutual funds easily and without fees. Funds, however, do charge an ongoing management fee. How to shop for other individual bonds Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying treasuries. Here’s my advice for doing it right and minimizing the chance of mistakes: Don’t buy through salespeople. Brokerage firms that employ representatives on commission are in the sales business. Many of the worst bond-investing disasters have befallen customers of such brokerage firms. Your best bet is to purchase individual bonds through discount brokers. Don’t be suckered into high yields—buy quality. Yes, junk bonds pay higher yields, but they also have a much higher chance of default. Nothing personal, but you’re not going to do as good a job as a professional money manager at spotting problems and red flags. Stick with highly rated bonds so you don’t have to worry about and suffer through these consequences. The 2020 COVID-19 financial market meltdown clobbered lower-rated bonds. Did you know what a subprime mortgage was before 2007, when stories of rising defaults were all over the news? Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default. Understand that bonds may be called early. Many bonds, especially corporate bonds, can legally be called before maturity. In this case, the bond issuer pays you back early because it doesn’t need to borrow as much money or because interest rates have fallen and the borrower wants to reissue new bonds at a lower interest rate. Be especially careful about purchasing bonds that were issued at higher interest rates than those that currently prevail. Borrowers pay off such bonds first. To buffer changes in the economy that adversely affect one industry or a few industries more than others, invest in and hold bonds from a variety of companies in different industries. Of the money that you want to invest in bonds, don’t put more than 5 percent into any one bond; that means you need to hold at least 20 bonds. Diversification requires a good amount to invest, given the size of most bonds and because trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond mutual fund or exchange-traded fund. Shop around. Just like when you buy a car, shop around for good prices on the bonds that you have in mind. The hard part is doing an apples-to-apples comparison because different brokers may not offer the same exact bonds. Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating. Unless you invest in boring, simple-to-understand bonds such as treasuries, you’re better off investing in bonds via the best bond mutual funds. One exception is if you absolutely, positively must receive your principal back on a certain date. Because bond funds don’t mature, individual bonds with the correct maturity for you may best suit your needs. Consider treasuries because they carry such a low default risk. Otherwise, you need a lot of time, money, and patience to invest well in individual bonds.

Cheat Sheet / Updated 03-27-2016

You may think of bonds as thoroughly modern financial instruments, but they have a long history. They played an important part in helping the Allies win World War II, for example. Every bond needs to be identified, which is where its CUSIP comes in. When you reach a certain age, the government requires that you begin withdrawing at least some money from your accounts, and you need to pay close attention to this, because if you don’t cash out the minimum amount, big fines are levied.

Article / Updated 03-26-2016

In a down economy, U.S. savings bonds are one of the safest investments you can make. Savings bonds are nonmarketable securities — when you purchase them, they’re registered to you and you can’t sell them to another investor. Uncle Sam offers two types of savings bonds, Series EE and Series I, which are backed by the full faith and credit of the U.S. government and are considered the safest of all investments. Here’s more info on each type: Series EE bonds: These bonds earn a fixed rate of return set by the U.S. Treasury. They’re accrual bonds, which means the interest accumulates and is compounded semiannually (rather than being paid to the owner as it’s earned each month). If you hold one of these bonds, you receive the interest when you redeem the bonds. Series I bonds: The interest you earn from I bonds comes in two parts: A fixed-rate component established when you purchase the bond A second component that’s equal to the rate of inflation, adjusted semiannually (based on the consumer price index for March and September) Although the fixed-rate interest component for Series I bonds is low, these bonds help protect you against inflation. If inflation goes up, so does the interest rate you earn because the variable-rate portion is adjusted every six months; for example, when the fixed-rate component is 2 percent and the inflation adjustment is 5 percent, an investment in a Series I bond is guaranteed to return 7 percent. But remember, the total interest rate can also go down as the inflation adjustment decreases. For both bonds, the purchase limit is $5,000 per Social Security number for each calendar year. You can easily purchase and redeem the bonds in electronic format through the Department of the Treasury’s Web site. If you purchase the bonds electronically, you can get any denomination of $25 or more, including penny increments. The purchase price is equal to the face value. You can also purchase the bonds in paper form through various financial institutions and payroll savings plans. Paper I bonds are offered in denominations of $50, $75, $100, $200, $500, $1000, and $5,000; they’re purchased for their face value. However, you can get paper versions of EE bonds at half their face value; they’ll be worth face value at maturity. Paper EE bonds are offered in denominations of $50, $75, $100, $200, $500, $1000, $5,000, and $10,000. The interest on both bonds compounds semiannually for 30 years, but you don’t have to hold the bonds for that long. You can redeem the bonds after 12 months, but you pay a three-month interest penalty if you redeem the bonds within five years of the purchase date. As for tax treatment, U.S. savings bonds are exempt from state and local income tax. Federal income tax on interest earned can be deferred until redemption or final maturity, whichever occurs first. Tax benefits are available when you use the bonds for education purposes.

Article / Updated 03-26-2016

Returns on savings bonds are so low that they’ll never make you rich. In fact, returns are so low that large pension funds and other big investors don’t purchase savings bonds. However, for many individuals, savings bonds are the best approach for saving money. Factors favoring savings bond are that you can Save automatically. Employers who sponsor savings bond programs can automatically deduct amounts you designate from your paychecks to purchase bonds. Diversify your risk. If you already have investments in stocks and bonds, you may want to invest in savings bonds. Doing so adds a no-risk element to your investment portfolio. End up with a safe investment. In exchange for a low return, savings bonds offer absolute safety for the principal investment; they’re absolutely no-risk investments. Avoid paying any sales commission. Investing in saving bonds doesn’t require the services of a broker to help you purchase them. Invest minimal amounts. The minimum investment in a savings bond is $25. If you subscribe to an employer-sponsored program, the minimum amount you pay each week can be even lower. Pay no or low taxes. The difference between the purchase price and the redemption value of Series EE bonds and the payment made on HH bonds comes in the form of interest. Interest income is subject to federal income tax but not state or local income taxes. You can defer paying federal income tax on the interest until you cash in the bonds. Gain educational tax benefits. The Education Bond Program allows interest to be completely or partially excluded from federal income tax when the bond owner pays for qualified higher education expenses at an eligible institution or state tuition plan in the same calendar year the bonds are redeemed. Disadvantages of savings bonds include the fact that you Face penalties for early redemption. If you cash in your Series EE bonds after you’ve held them for six months, you’ll pay three months’ worth of interest — ouch! Series EE and Series I bonds cease paying interest after 30 years. Need to be careful when you redeem your bonds. Make sure that you know when interest is posted. If you redeem a bond right before interest is posted, you won’t reap your interest payment. If you redeem your bond early on in the same month that interest is posted, you may lose six months’ worth of interest. Sometimes you can spend and save at the same time. At BondRewards, you can shop online at your favorite stores (more than 150 online stores participate in the program) and receive a small percentage of your purchase price in the form of a U.S. Savings Bond. Check in your safe-deposit box or among the papers of elderly relatives for old bonds. More than $2 billion in savings bonds never have been redeemed.

Article / Updated 03-26-2016

When most investment professionals look at the world of global fixed income, they see two large categories of international bonds: developed-world bonds and emerging-market bonds. Developed-world bonds Just as the U.S. government and corporations issue bonds, so too do the governments and corporations of Canada, England, Sweden, Japan, and many other countries, large and small, rich and not-so-rich. It may be difficult to find a decent sirloin in some of these lands, but that doesn't mean their fixed-income offerings are all chopped meat. Foreign bonds, like U.S. bonds, come in all sorts of maturities and credit qualities. Some are dollar-denominated; these are often called Yankee bonds. But most are denominated in the currency of their home countries. Over the long run, you can expect that bonds of similar credit quality and duration, bearing similar risk, should yield roughly equal returns, no matter which country they are issued or sold from. After all, if, say, British bonds consistently paid higher rates of interest than U.S. bonds, investment money would float eastward across the big pond. U.S. bond issuers would eventually either have to up their coupon rates or raise capital in another way, like hosting bake sales or bingo games. In the short run, however, interest rates can vary among bond markets, and more importantly, exchange rates can fluctuate wildly. For that reason, U.S. investors putting their money into foreign fixed income are generally looking at a fairly volatile investment with modest returns. (All fixed-income investments generally see modest returns.) On the flip side, foreign bonds, especially non-dollar-denominated bonds, tend to have limited correlation to U.S. bonds (meaning their value is independent of U.S. bonds), so owning some foreign fixed income in developed countries can be a sensible diversifier. Emerging markets Emerging markets is something of a euphemism for "poor countries." Those who invest in them hope that these nations are emerging, but no one can say with any certainty. In any case, if you want to buy bonds issued in Brazil, Turkey, Russia, Venezuela, Mexico, or Argentina, the opportunities are out there. The interest rates can be nose-bleed high, but the volatility can make your stomach contents emerge, too. The majority of emerging-market bonds are so-called sovereign bonds. All sovereign means is that these bonds are issued by federal governments, not corporations. U.S. Treasury bonds are sovereign bonds. Unlike the bonds issued by developed nations, most emerging-market bonds are dollar-denominated. Still, given the problems of these nations, the governments can be shaky. To get enough people to lend them money, they must pay high rates of interest. Very high. With the high return, as always, comes high volatility. In 1998, when Russian government bonds went into default, investors in the Fidelity New Markets Income Fund, like investors in most emerging-market funds, quickly saw about a quarter of their investments disappear overnight. The following year, most emerging-market bond funds sprung back rather nicely, even though Ecuador defaulted on its bonds that year.

Article / Updated 03-26-2016

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.