Bond Funds

The problem with buying individual bonds is that their market is much smaller due to many thousands of issues. With only a few buyers of each issue, liquidity is low. A minimum investment is also required. Furthermore, buying larger quantities is often required to get lower prices. Most brokerages also charge a commission and there may be an additional markup charged by dealers who offer the bonds for sale, so buying and selling individual bonds is certainly more expensive than buying and selling stocks or other securities on public exchanges.

Investing in bond funds avoids many of the problems of buying and selling individual bonds and avoids much of the risk of individual bonds. A bond fund is a managed portfolio of bonds, organized as a mutual fund, an exchange-traded fund (ETF), a closed-end fund (CEF), or a unit investment trust (UIT). A fund's manager invests in bonds meeting the criteria specified by the fund's objective. Hundreds of bond funds are available.

Bond funds provide instant diversification across many bonds of varying maturities and may even provide diversification among different sectors, such as government and corporate bonds or domestic and international bonds. Bond funds are also managed professionally by experts who have greater knowledge of the bond market than most retail investors. Moreover, exchange-traded bond funds are much more liquid since a fund trades as a single security even if it has thousands of different types of bonds. Shares of mutual funds can be bought or sold from the mutual fund based on its net asset value at the end of the trading day.

The main risk of bond funds is interest rate risk, which also affects individual bonds. Rising interest rates will cause bond prices to decline, so funds consisting of bonds will be similarly affected. However, credit risk is less with funds than with individual bonds since funds are usually diversified and the bonds are picked by professional managers who can more easily assess credit risk than individual investors.

Bond funds can be classified under general categories and subcategories, such as these:

General

Corporate Bond

Government Bond

Municipal Bond

Specialty

Money Market

In the United States, the broadest categories of bond funds based on yield, risk, and the taxability of the interest include funds based on:

Treasuries and money market funds are the safest securities, and corporate bonds have greater risk, but that risk can vary depending on the creditworthiness of the companies issuing the bonds, ranging from safe AAA corporate bonds to junk bonds. Treasuries and money market funds have the lowest yields because they are the safest securities. Treasuries have the additional benefit that they are not taxed by state or local governments, but they are taxed by the federal government.

Many municipal bonds also have tax advantages, but this will depend on the bond issuer, the purpose for the bond, and may also depend on the domicile of the buyer. Some municipal bonds are exempt from federal, state, and local taxes (triple-exempt), depending on the issuer and the residency of the bondholder. Municipal bonds purchased from a municipality in which you live will often have the best tax advantages. Note, however, that some municipal bonds that benefit private parties may be taxable at the federal, state, and local level.

Corporate bonds and money market funds have no special tax exemption.

Fund Organization

Funds are organized as open-end mutual funds, exchange-traded funds, closed-end funds, and unit investment trusts.

Most people invest in bonds by investing in open-end mutual funds, which are the most common type of fund organization, so common, that most people just refer to them as mutual funds.

Most mutual funds are open-ended funds, which sell new shares continuously or buy them back from the shareholder (redeems them), dealing directly with the investor (no-load funds) or through broker-dealers, who receive the sales load of a buy or sell order. The purchase price is the net asset value (NAV) at the end of the trading day:

The number of shares of an open-end fund varies throughout its existence, depending on how many shares are bought or redeemed by investors.

A major disadvantage to open-end funds is that they need cash to redeem their shares for investors who want out, so they either must keep a lot of cash, which earns only the current prevailing interest rate, or they must sell securities to raise the cash, possibly generating capital gains taxes for the remaining investors of the fund.

Mutual funds may also have fees associated with specific activities that may total from .5% to 8.5%, the legal maximum.

No-load funds do not charge a front-end sales charge or a deferred sales charge. FINRA rules also require that the 12b-1 fees not exceed 0.25% of the fund's average annual net assets to call itself a no-load fund.

Exchange-traded funds (ETFs) are investment companies that create and sell shares in a fund representing a beneficial interest in the holdings of the fund, which can include stocks, bonds, and other securities, and these ETF shares are traded on a stock exchange, and are bought and sold through a broker-dealer, just like a stock.

Mutual funds and exchange-traded funds are similar, in that they both represent a basket of securities that lowers volatility and risk, but they have different advantages and disadvantages for investors.

A closed-end mutual fund, also known simply as a closed-end fund (CEF), sells shares in an initial public offering (IPO). After the offering, no more shares are created or redeemed. Therefore, less money is needed to manage the fund since dealing directly with individual investors, such as sending periodic statements, is avoided, and it also eliminates redeeming shares to pay investors who want to cash out, such as occurs in open-end mutual funds. Consequently, a closed-end fund can be more fully invested since it doesn't need as much cash, and it is more tax efficient. Because CEFs do not have to redeem shares, they can invest in more illiquid securities or longer-term debt that may yield a higher return. However, most CEFs offer few shareholder services. Most have dividend reinvestment plans, but little else.

The main advantage of CEFs over mutual funds is their higher yield. CEFs do not have to maintain liquidity for redemptions, and they can typically be bought at a deep discount to their net asset value. Because CEFs are bought for their income, being able to buy at a discount can significantly increase the yield of the investment. Moreover, the fund manager may decide to liquidate the fund if it consistently sells at a discount, in which case, investors will receive the net asset value. The main possible advantage over exchange-traded funds (ETFs) is that CEFs are actively managed and can use leverage to increase returns. Unlike open-end mutual funds, they can issue debt or sell preferred shares to increase their leverage, which may increase profits.

Most CEFs are perpetual funds, but some are term funds that will liquidate on a particular date at the net asset value at the time of liquidation. Since many of these funds can be purchased at a steep discount, you not only earn a nice yield, but you may also earn a substantial gain when the market price converges to the net asset value as the termination date approaches, assuming, of course, that the net asset value is maintained or increased.

Disadvantages of CEFs include higher management expenses, often exceeding 1%, compared to no-load mutual funds or index funds and CEFs are only required to disclose their portfolios quarterly or semiannually.

Before buying a closed-end fund, keep these points in mind:

For the reasons stated above, it is best never to buy a fund as part of an IPO — buy it on a stock exchange, especially if it is trading below its NAV and especially if it pays interest since a CEF trading at a discount will have a higher yield.

Unit investment trusts (UITs) are fixed portfolios of a particular asset class that were created to effect some particular investment strategy in a limited timeframe that ends on the maturity date for the fund. UIT sponsors issue securities representing an undivided interest in the principal and income of a fixed portfolio of securities, usually consisting of bonds, but may also include mortgage-backed securities, or preferred or common stock. Unit investment trusts terminate either when the bonds mature or on a specified date, so they have a maturity date, just like bonds. However, like mutual funds and closed-end funds, UITs have numerous fees, including an initial sales charge, deferred sales charges, and other fees and expenses. Most UITs cannot be purchased on public stock exchanges. They must be purchased directly from the issuer or from brokers offering these securities, who will add their own commissions to the sale. If you want to dispose of a UIT before maturity, then you must redeem it with the issuer at the NAV. Although some UITs have a secondary market, the secondary market is a specialized network, not a major public exchange, so they do not have the liquidity of ETFs on public exchanges.

Fees. The return of bonds is usually much less than the return from stocks, and the same is true of bond funds. Therefore, the fees charged by a fund are a much more important consideration since fees can significantly lower the return of a bond fund. This is especially true for bonds in a mutual fund, where hefty sales commissions may be charged, many times as a sales load, which is a sales commission charged even before any money is invested and may be 5% or more of the investment. Though fees are lower for closed-end funds and unit investment trusts, fees are still higher than for exchange-traded funds, and ETFs are much more liquid. (More: Mutual Fund Fees and Expenses, Expense Ratio)

Active management versus passive management. The 1st distinction among bond funds is that some are actively managed, where the manager of the fund chooses the bonds periodically for the portfolio. Other bond funds are based on indexes, where the bonds are selected to mirror a particular index, and thus, are passively managed.

It is debatable as to whether actively managed funds do better than passive index funds, especially since actively managed funds charge higher fees. Many studies have shown that actively managed funds failed to outperform passive index funds over an extended period, just as with stock funds. Many active funds do better than passive funds over a few years, but few funds maintain the outperformance. Nonetheless, it is widely believed that active bond managers can do better than active stock managers due to the much greater variety of bonds, so specialized knowledge can yield better results when managing a bond fund.

A great way to tell if an actively managed fund is actually better than a passive fund is to compare the past performance of each fund over an extended time. Many financial websites make it easy to compare securities by providing charts showing past performances of several securities on the same chart.

How to Pick a Bond Fund

When picking a fund, 1st decide on what types of bonds you want to own. If you want safety, you might prefer Treasuries, or you might pick agency bonds for a slightly higher yield with only a slightly higher risk. And, of course, municipal bonds are exempt from federal taxes and may also be exempt from state and local taxes. Or you might prefer high-yield corporate bonds if you're willing to risk more for a higher yield.

Municipal bonds only make sense if you are in a high tax bracket and the funds are going to be held in a taxable account. If the funds are going to be held in a retirement account, then municipal bonds should not even be considered since you will not benefit from the tax exemption. Only fully taxable municipal bonds should be considered for retirement accounts.

It is best to own high-yield corporate bonds if interest rates are low, because usually the default rate is much lower than when interest rates are high. And even if interest rates rise, high-yield corporate bonds will suffer less from price declines than investment-grade bonds because interest rate sensitivity declines with higher yields. On the other hand, when interest rates rise, the default rates of many businesses with poor credit ratings will also rise because it will be more expensive to refinance debt.

Duration. After deciding what type of security you want to hold, you should select an average duration. Shorter durations are less volatile but longer durations offer a much greater capital gain potential when interest rates decline. So, when interest rates are high, long-duration funds consisting of long-term Treasuries will be best since they not only offer high interest rates, but they have the greatest potential for capital gains when interest rates decline. Although these funds are volatile, the interest rate risk usually associated with long-duration securities is much less when interest rates are already high since it is less likely that interest rates will rise further. High interest rates for an extended time will have a devastating effect on the economy, so central banks will lower interest rates to prevent a recession. Moreover, bonds will decrease in price less with each additional unit increase in interest rates when interest rates are already high, meaning that there is less downside risk and more upside potential when rates are already high.

Morningstar Ratings

With about 30,000 funds to choose from, many investors rely on Morningstar ratings to make better selections. Morningstar rates most funds. You can search for funds with particular Morningstar ratings by using the free Fund Analyzer, discussed below.

Morningstar ratings range from 1 star to 5 stars, from worst to best. Morningstar ratings may be assigned by an analyst or are determined by quantitative algorithms that allow Morningstar to scale its fund coverage.

The rating is a forward-looking measure of Morningstar's confidence in a fund's ability to beat its peers through a market cycle, after accounting for fees and risk. A rating of 3 or above indicates that analysts expect a fund to outperform its peers over a full market cycle; ratings below 3 mean that Morningstar's analysts doubt that the fund will be able to outperform its peers.

A fund's rating is based on an assessment of the fund managers' approach to their investment strategy, of the individuals who manage the fund, and of the asset manager that offers the fund. These assessments also account for other factors like price and performance. The relative impact of each factor on the overall rating depends on whether a fund is actively or passively managed. Ratings of actively managed funds are based more on the assessment of the individuals managing the fund.

FINRA's Fund Analyzer

The Financial Industry Regulatory Authority (FINRA) provides a great search tool for funds, called the Fund Analyzer (https://tools.finra.org/fund_analyzer/), that allows you to sort and compare 30,000 mutual funds, exchange-traded funds, exchange-traded notes, and money market funds. You can search by fund name, family, ticker, or keywords.

The Fund Analyzer automatically applies a fund's applicable fees and commonly available discounts and does the math for you, showing how fees and expenses impact the value of your investment over time.

For instance, you can search for all the Vanguard funds that will display the name of the fund, the ticker symbol, load type, annual expense ratio, and the fund category, including whether the fund is taxable or tax-free. And you can sort by any of these categories.

Many additional filters can be applied, such as searching for exchange-traded funds or exchange-traded notes, money market funds, or mutual funds. Filter by share class and by fund objective, such as small company, aggressive growth, asset allocation, and world stock. Search specifically for corporate bonds, government bonds, municipal bonds, and specialized funds, such as for technology, precious metals, communications, and so on. Specify the maximum annual operating expenses or restrict the choices by Morningstar styles or ratings or by Morningstar categories, such as energy limited partnerships or high yield bonds.

Funds can also be marked as a favorite to allow easy comparisons of up to 3 funds.

Finding the Best Funds

Many books on bonds offer a list of what the authors think are the best funds, but always do research before investing, because lists become outdated. So, my emphasis in this section will be to present methods you can use to pick the best funds.

The Internet provides tremendous information on any fund. Issuers of bond funds have websites with detailed information on their products, and many tools are available to ease and enhance selecting a fund. The Fund Analyzer is 1 of the best tools available, allowing easy searching and selecting among thousands of funds. Give priority to reading information provided by the issuer of the security since that information will be more reliable and more complete.

The first step is to select the type of fund:

The next step is to decide what your primary objective is, such as high income, capital preservation, or inflation protection. You can also select funds based on distribution frequency, such as monthly or quarterly.

The next step is to search for funds with the lowest fees. While the percentage differences are often not that great, these differences will expand over time due to compounding. Vanguard was 1 of the first issuers to offer the lowest fees. Many of their bond funds charge only.03%, or $30 for every $10,000 invested. However, issuers have become more competitive, so you can find many funds with low fees.

The next step is to choose the duration. This will depend on prevailing interest rates. When interest rates are low, you may want long duration bonds for a higher yield, but unless you are willing to hold to maturity, you should sell if any signs indicate that interest rates will start rising since bonds with longer duration will decline more in price when rates rise. You can also select high yield funds since they have less interest rate risk. A corporate bond fund may offer a higher yield with a better credit rating.

When interest rates are rising, it is best to select securities with the shortest duration since they have the least interest rate risk, and you can reinvest sooner for a higher yield as interest rates climb.

When interest rates are at their peak, then you may want to choose securities with the longest duration because they will have the maximum potential for capital gains, and they will pay a high yield. The best way to tell if interest rates are at or near their peak is to read reports about the Federal Reserve since the Federal Reserve largely influences interest rates by adjusting the federal funds rate. Interest rates are usually increased to slow the economy or to subdue inflation, so the Fed will lower interest rates when the economy starts to slow, or inflation falls.

Refining Your Selection

A great way to refine your selection is by looking at the historical performance of each security you are considering. Many websites provide charts of past performance for many securities, including bond ETFs. Here is a small sample:

Consider both short-term and long-term performance and pay attention to periods of market volatility.

Bond Indexes

Many bond funds base their selection of securities on popular indexes of bonds. Many bond indexes exist, some are very specialized, such as the Short-Term California AMT-Free and the Long-Term National AMT-Free. Some indexes also cover bonds issued in other countries, such as Canada, France, Germany, Japan, United Kingdom, and emerging markets. You can find a list of these indexes on financial websites, such as Bloomberg and the Wall Street Journal.

Search: bond indexes

The S&P 500 Bond Index is designed to be like the S&P 500, widely regarded as the best single gauge of large-cap U.S. equities. Market value-weighted, the index seeks to measure the performance of U.S. corporate debt issued by S&P 500 companies.

The S&P U.S. Aggregate Bond Index is designed to measure the performance of publicly issued U.S. dollar denominated investment-grade debt. The index is part of the S&P Aggregate Bond Index family and includes U.S. Treasuries, quasi-governments, corporates, taxable municipal bonds, foreign agency, supranational, federal agency, and non-U.S. debentures, covered bonds, and residential mortgage pass-throughs.