Bond Funds FAQ

Having trouble picking a bond mutual fund or maybe just confused by the seemingly endless variety of bond funds out there?  The following Bond Funds FAQ will help you out.

By the way, the best way to get detailed information on any bond fund is by signing up for a free Morningstar account.

Bond Funds FAQ

How Do I determine a bond fund’s risk?

The quickest and most direct way to estimate a bond fund’s likely future volatility is by a statistic called average duration.  In layman’s terms, average duration is a measure of how sensitive a bond fund is to changes in interest rates.  A fund with an average duration of 5 years will lose 5% of its value for every 1% rise in interest rates (and appreciate 5% for every 1% drop in interest rates).  Similarly, a bond fund with a 10 year average duration will gain or lose 10% of its value for every 1% change in interest rates.  A fund’s average duration is directly correlated to its average maturity, so long-term funds will tend to be more risky than short-term funds.  You can get average duration numbers from Morningstar.

How Will Bond Funds React To Inflation?

Generally, the market sets interest rates high enough to eke out real, positive inflation-adjusted returns when inflation is relatively moderate and stable.  It is during periods of rapid changes in the rate of inflation that things get unpredictable.  If you buy a bond fund when inflation is low and inflation suddenly picks up, you might not fare so well in the short term; however, over the long term the bond market should compensate you with positive inflation-adjusted returns.  Generally speaking, funds with a longer average maturity will be much more sensitive to changes in the rate of inflation than those with shorter maturities.

Which Is better Index Or Actively-Managed Bond Funds?

I am a huge proponent of indexing whenever possible, and indexing is arguably even more effective with bonds than it is with stocks.  Why?  Because since bonds have a lower expected return than stocks, the drag of high expenses is even more noticeable.  I wholeheartedly recommend bond index funds over actively-managed funds.

What’s A Reasonable Expense Ratio For A Bond Fund?

Vanguard’s Total Bond Market Index Fund (VBMFX) charges just 0.22% of assets, and there’s little reason to think more expensive funds will out-perform it over the long run.  In certainly don’t think you could justify paying more than 0.50% for a bond fund, which is more than twice what Vanguard charges.  Unfortunately, many 401k plans don’t contain any bond funds even close to that price, so you may have to get create or just bite the bullet and pay the higher costs.

Where Can I Buy A Bond Fund?

You can purchase bond funds either through your 401k at work, a discount brokerage like Tradeking or Zecco (most don’t charge a purchase fee if you choose from a pre-selected list of fund families), or directly at your mutual fund company of choice, be it Vanguard, Fidelity, or some other fund provider.