How To Choose A Bond Mutual Fund

2009 August 26

Choosing a bond mutual fund has a lot in common with choosing a good stock mutual fund.  Many of the same rules apply to both stock and bond mutual funds; however, bond funds are on the average even less complicated and easier to choose.  I’m going to assume for the purposes of this article that you’re already familiar with modern portfolio theory and the agree you should allocate at least a portion of your portfolio to bonds.

By the way, the best way to get detailed information on any mutual fund is by signing up for a free Morningstar account. You can find all the statistics mentioned below plus dozens more at Morningstar.

Attributes Of A High-Performing Bond Mutual Fund

First, I’ll highlight a few attributes good stock and bond funds tend to have in common.

  • Low Expenses – Since bonds have lower expected returns than stocks, high expenses cut even deeper into the returns of bond funds than stock funds.  It’s doubly-important to keep a lid on expenses here.
  • Index Funds Rule - Indexing works just as well with bonds as with stocks.  Better, perhaps, because of the even greater importance of low expenses in the bond world.  Just like their stock counterparts, most actively-managed bond mutual funds fail to beat their relevant index.
  • Diversified – It goes without saying that good bond funds are usually broadly diversified, owning hundreds if not thousands of bonds across multiple durations and market segments.

Bond-Specific Attributes

  • Average DurationDuration is a measure of a bond fund’s sensitivity to changes in interest rates.  The lower the duration, the less volatile the fund will likely be.  An average duration of 4 means that particular fund’s Net Asset Value (NAV) would be expected to drop 4% for every 1% rise in interest rates (and vice versa).  As a point of reference, Vanguard’s Total Bond Market Index Fund (VBMFX) has an average duration of 4.3 years, meaning it will fluctuate 4.3% for every 1% change in interest rates.
  • Yield To Maturity – The yield to maturity is simply the current interest rate a bond fund is paying.  Assuming interest rates remain steady, yield to maturity is also the expected annual return of the portfolio.
  • Average Maturity – All else being equal, the nearer a bond’s maturity the lower its interest rate and the less volatile it will be.  Of particular importance is the fact that long-term bonds (10 years or more) tend to be very vulnerable to inflation and usually suffer poor returns during inflationary periods.
  • Credit Quality – All else equal, higher-quality investment grade bonds tend to pay slightly lower interest rates than lower-rated junk bonds, but also tend to have a much lower default rate.  Junk bonds, on the other hand, tend to pay higher interest rates to compensate for the higher risk of default.  There are no guarantees going forward, but historically junk bonds have not yielded high enough returns to compensate investors for the additional risk they’ve had to take on to own them.

The Bond Style Box

Looking up a fund’s bond style box on Morningstaris a quick and dirty way to make a quick assessment of all the above factors.  The style box is simply a 9×9 grid comparing maturity and credit quality.  The box on the grid a bond mutual fund belongs to will explain 95% of its future performance characteristics. Here’s an example of the bond style box you would see for a long-term corporate bond fund.

Avg. Weighted Maturity
Short Med Long
Treasury/
Agency
Quality
Inv.-Grade
Corp
Below
Inv.-Grade

The above style box tells you everything you need to know about the fund in question at a glance.  As you can see, it is characterized by a long maturity and medium credit quality.  Its yield to maturity and average duration are likely to closely mimic other bond mutual funds belonging to the same style box.

One more example, this time that of a short-term treasury bond fund.

Avg. Weighted Maturity
Short Med Long
Treasury/
Agency
Quality
Inv.-Grade
Corp
Below
Inv.-Grade

The above fund, having a short maturity and very high credit quality, likely has a yield to maturity on the low end of the spectrum; however, it is also probably a good bit less volatile than funds in any other the other 8 style boxes.  Again, visiting Morningstar is the quickest and easiest way to find a bond fund’s style box.

Armed with the basic facts above, you’re well on your way to choosing your first bond fund.  Now it’s simply a matter of deciding exactly how much volatility you are willing to tolerate and how high a yield you’re going to require as compensation.

For a much more in-depth look at what bonds are an exactly how they work, I recommend The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More byAnnette Thau.

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4 Responses
  1. 2009 August 26
    Average Investor permalink

    Do you recommend putting money into bind funds at this point in time given the interest rates are probably only going to be going up for some time now. How would any money going into a bond fund at this time realize any appreciation?

    btw, great blog.

  2. 2009 August 26
    Average Investor permalink

    Do you recommend putting money into bond funds at this point in time given the interest rates are probably only going to be going up for some time? How would any money going into a bond fund at this time realize any appreciation?

    btw, great blog.

  3. 2009 August 27
    Anonymous permalink

    Exactly what is an acceptable range for a bond fund expense ratio?

  4. 2009 August 30

    Average Investor: I believe any time is a good time to put money into bond funds if it’s part of your asset allocation. I don’t advocate trying to outguess the market. I don’t think it’s a foregone conclusion that interest rates must rise from here anytime soon. They might, but deflation is also a possibility.

    Anonymous: I would be hesitant to pay more than 0.30% for a domestic bond funds. You can find plenty of index funds for less than that. Foreign bond funds are more expensive, but I still probably wouldn’t pay more than 0.60%. Less is better.

Comments are closed.