Don't forget about risk, taxes, costs and other basic matters - MORNINGSTAR - By Paul Herbert
In the past we've geared our first Bond Squad article of the year toward pointing out a few funds we thought looked like good picks at that time. But with yield spreads between short- and long-term and with high- and low-quality bonds looking so slim coming into 2007, there are fewer screaming buys today.
As a result, it seems like a good idea to pose a more basic question facing investors: "How do you pick a good bond fund in the first place?" It's a topic we haven't approached in several years and one that needs answering regardless of the opportunities present (or absent) at any particular juncture.
1. Mind the Risks
It's true that when you're looking over your fund account statements, you won't see the value of your short-term bond holding swing around as much as the balance in your emerging-markets stock fund. Nonetheless, there are many risks that bond funds face. But while it may make sense to keep several perils in mind as a fixed-income investor--like currency risk for non-U.S. obligations or prepayment risk for mortgage-backed securities--we think interest-rate risk and credit risk are enemies numbers 1 and 2.
To understand interest-rate risk, think like a bond investor. Let's say you own a bond with a 3% coupon, and market interest rates move up to 5%. Bonds with coupons commensurate with this new higher rate will have become widely available, making your bond worth less to a potential buyer. This reality would affect owners of all fixed-rate securities, but not in the same way. Those who own bonds with longer maturities would suffer more. Intuitively, this makes sense because these folks have many years of below-market coupon payments still coming to them.
Adopting this same mindset helps as we turn to credit risk. When you buy a bond, you're loaning money. Credit risk refers to the danger that the borrower--a government entity or a company, for our purposes--won't be able to make good on the loan. There isn't much of a need to worry that the U.S. Treasury or a government agency won't be able to pay you back, but that apprehension is real when it comes to certain corporations on the hook for repayment. A company's earnings (from which you'll be repaid interest and principal) will fluctuate as demand for its wares and the health of the economy do, introducing some uncertainty into the matter of whether it will be able to return your money to you. Companies that run into the direst of situations declare bankruptcy. But the bond prices of firms that aren't approaching that scenario can also flop around as perceptions of their ability to meet claims change.
In general, investors who are more concerned about interest-rate risk will want to flock to shorter-term bond funds, such as those residing in our ultrashort, short-term, and muni national short categories. For those looking to limit credit risk, it makes sense to favor government-bond funds over high-yield, high-yield municipal, and emerging-markets funds.
2. Respect the Taxman
The obvious point of this section is that tax-conscious investors who have maxed out their tax-sheltered accounts should consider investing in muni bonds or funds that hold them. The income that these vehicles produce isn't subject to income taxes from the federal government and may be exempt from state and local taxes, too. Tax-free bonds have lower stated yields than their taxable counterparts, but they may be a better deal after you consider that Uncle Sam won't be taking a significant amount of that income for himself. And that's the more timely point from this discussion: As we sit here in early 2007, a case can be made for munis for some investors. A generic 10-year AAA municipal-bond carries a yield of 3.81%, while a 10-year U.S. Treasury note yields 4.77%. An investor in the 25% tax bracket should pick the tax-free issue, which has a tax-equivalent yield of 5.08%. Investors in higher tax brackets would enjoy an even bigger advantage from holding the muni bond.
3. Wishing You Many Happy (Total) Returns
We just finished talking about different bonds' yields, but as a broader point it makes sense for many investors to focus on a bond's (or a bond fund's) total return rather than its yield. Why? Yield may help you compare one bond or fund with another, but total return provides a better picture of an investor's experience. As suggested in section 1 above, bond prices may vary based on changes in interest rates and issuers' financial situations. If you only paid attention to the yield of a fixed-coupon bond, you wouldn't notice these movements. Total return captures this capital appreciation or depreciation.
4. Expenses Can, Do, and Probably Will Matter
Low-cost funds start out with a leg up on their rivals because fees detract from total returns. And this low-expense advantage isn't just theory, it's reality: More than two thirds of intermediate-term bond funds with top-quartile performance during the past 10 years have expense ratios lower than 0.75%. Plus, expenses have proved to be a reasonable predictor of future returns across categories. This is great news for investors in Vanguard funds, which carry expense ratios of no more than 0.26% as of 2006. Experienced fund investors can probably point to more expensive funds with great track records, too, but in general we think it's more of a slam dunk to cheap out.
5. Think Outside the Box (But Don't Think Too Hard Right Now)
Many investors confine their bond-fund purchases to offerings from our general bond categories, but that doesn't mean that there aren't great managers who run strategies that defy conventions. As long as you stay committed to low-cost options, you can do your portfolio some good by picking up a high-yield fund to spice up returns or a TIPS fund to protect against the harmful effects of inflation. It's worth pointing out, however, that many types of noncore bond funds don't look like outstanding deals today--including funds that focus on high-yield bonds, TIPS, high-yield munis, bank loans, and emerging-markets debt. That doesn't mean that offerings from these categories aren't good ideas for the long term, but those who chase hot funds in these areas are likely to be very disappointed.
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