Field Guide to Bond Funds

By Michael Trovato
Analyst, mPower

In This Story What is a Bond Fund? Prices, Interest Rates and Duration Treasuries Corporate Bonds Mortgage Bonds Diversified Bond Funds Municipal Bonds Fees and Risk

Although unfortunate for many, the stock market's tumble may have been a blessing in disguise. Many investors moved blissfully through the 1990s believing their portfolios would double each year, ensuring them an early retirement and a stately mansion. "Why not load up on technology stocks?," they wondered. "Bonds? Who needs 'em?"

Everyone knows what happened next. During 2000, the S&P 500 fell over 9 percent and the technology-heavy NASDAQ got creamed to the tune of a 39 percent loss. Meanwhile, the bond market had its day in the sun, cruising to an 11.6 percent return, as measured by the Lehman Brothers Aggregate Bond Index.

minute: read this article at a glance.

Technical Terms Benchmark Index fund Interest Risk Sector Volatility

The lesson to be learned from this is the importance of keeping a balance of investments in your portfolio. Diversification was not a sexy topic for investors who saw massive returns in their technology funds during the 1990s and poured even more money into them as a result. Now that those funds are hurting, diversification is in vogue, and bonds have become interesting again.

So you may want to know: What is a bond fund? Should I buy short-term or long-term funds? Which bond sectors fit into my investing strategy? What fees should I expect?

Here are some guidelines to help you understand bond fund basics.

What is a Bond Fund?

A bond is a debt security, similar to an IOU. When a bond is purchased, the investor is lending money to a government, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay the bond owner a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures," or comes due.

"Diversification was not a sexy topic for investors who saw massive returns in their technology funds during the 1990s and poured even more money into them as a result. Now that those funds are hurting, diversification is in vogue, and bonds have become interesting again." — Michael Trovato, analyst at mPower Advisors, L.L.C.

The basic bond types are: U.S. Treasuries, municipal bonds, corporate bonds ("corporates"), mortgage and asset-backed securities, federal agency securities and foreign government bonds. Of these, U.S. Treasuries, corporates and mortgage securities make up most of the core domestic bond market.

A bond fund is a mutual fund that invests primarily in one or a combination of these types of bonds.

Prices, Interest Rates and Duration

Between the time that a bond is originally issued and the day it matures, its price in the marketplace will fluctuate according to changes in market conditions. This is particularly important for bond funds, as most mutual fund managers do not hold all bonds until maturity.

Bond prices are most susceptible to changes in interest rates. When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues. That's because investors want the best rate available in the market. When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues. The degree of the price change depends on the bond's duration.

Duration is the key measure of bond risk. It measures how sensitive a bond is to changes in interest rates. Long-term bonds are more sensitive to interest rate fluctuations than short-term bonds, and typically have higher durations.

Longer duration bonds typically yield more than short duration bonds, because investors demand higher return for the increased volatility that comes from the higher sensitivity to interest rate fluctuations. Does the higher yield mean you should invest everything in long-duration bonds? Definitely not.

The example below shows the risk/return tradeoff for extending a bond's duration. The investor is rewarded 3.5 percent more in return, but in order to get those gains, her portfolio experiences nearly five times the volatility. The numbers confirm what many studies have shown — that investing in longer duration bonds means taking on a disproportionate amount of risk.

You should know the duration range of a bond fund before you invest in it. This information is typically found in the fund's marketing material, and is sometimes indicated in the title of the fund. Short-term funds will typically be in the 1-3 year duration range, intermediate-terms hover around 3-7 years, and long-term bond funds will have average durations longer than seven years.

In addition to duration, many funds focus on particular bond types and invest in one particular sector or combine sectors to increase returns and reduce risk. The main sectors are Treasuries, corporate bonds and mortgage bonds. You can also find diversified funds.

Treasuries

Treasury securities are issued by the U.S. Department of the Treasury and are backed by the U.S. government. The U.S. government is regarded as the most creditworthy entity in the world, and Treasuries carry the highest rating (AAA+) by Standard & Poor's. With over $5.7 trillion in outstanding debt, Treasuries are widely viewed as safe and liquid securities. You can invest in them either individually or through a bond fund.

Due to their superior credit quality, government bonds pay lower yields than mortgage or corporate bonds with similar durations. They are often the target of investors' "flight to quality" during volatile times and are purchased as a "safe haven." Consequently, they tend to perform well when the remaining bond or stock markets begin to stumble.

Government bonds returned 12.3 percent over the year ended March 31, and the volatile equity markets were only half the reason for their outstanding performance. The returns were also assisted by a unique supply and demand situation that developed early last year.

A booming economy during the 1990s generated large tax revenues, which led to a government budget surplus. That change fostered speculation that the popular 30-year Treasury bond was near extinction: Why would the government borrow when it didn't have to?

The Treasury did follow through with a buyback program, and bought (or "retired") expensive, long-term issues that paid high coupons and also cut back in new 30-year bond issuance. The resulting supply reduction coupled with speculation that these securities would disappear led bond managers to dramatically bid up prices. Those who had a lot of Treasuries in their portfolios enjoyed a great year as a result.

Corporate Bonds

For higher returns, investors who are willing to undertake more risk can choose corporate bonds. Corporate bond investors basically lend their money to companies in exchange for its return at a later date and regular (usually semiannual) interest payments. The corporate bond market totals $3.4 trillion.

Corporate bond investors should be familiar with the bond-rating system, which evaluates issuers' creditworthiness, or likelihood that they will pay back their debts. Securities (or funds) with a BBB or higher rating by Standard & Poor's, Fitch, or Duff & Phelps, or Baa or higher by Moody's, are considered investment grade. Bond ratings below this threshold are considered high yield or "junk" and are considered much more speculative.

Bond fund managers will typically invest in a wide range of credits, focusing on the higher-tier credits when the economy struggles, and taking on more risk during economic surges by investing in lower-grade bonds. Before investing in a bond fund, you should know its average credit quality and to what degree its management is able to invest in lower-tier credits. You can find this information in the prospectus.

High-yield bonds had a miserable year in 2000, as they tend to have a high correlation with the stock market. Investment-grade bonds, on the other hand, rallied as many bond investors made a "flight to quality." Over the year ending March 31, 2001, investment-grade bonds returned 12.2 percent compared to 2.5 percent for high-yield bonds.

Mortgage Bonds

Perhaps the most complex securities in the core bond universe, mortgage bonds come in many different structures. Typically, they are pools of mortgage loans that are resold to the public. These securities are offered by a U.S. government agency (Government National Mortgage Association, or Ginnie Mae) or government-sponsored agencies (GSEs) such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

These agencies have very strong credit histories, and investors who buy mortgage bonds take on virtually no credit risk. The risk for mortgage bonds, however, lies in what is known as prepayment risk.

Like most bonds, mortgage securities pay interest on the loan in the form of coupon payments, but investors also receive repayments of their principal in increments over the life of the security. The rate at which mortgage investors receive their principal depends on the level of refinancing activity by homeowners.

Mortgage securities are typically superior performers in stable interest rate environments, but when interest rates fall, homeowners often refinance their mortgages by prepaying their original loans. This prepayment cash flow crimps returns to mortgage bondholders, who are forced to reinvest the money at lower rates. To compensate for this risk, mortgage-backed bonds typically pay higher interest rates than Treasuries.

Recent rate cuts by the Federal Reserve Board didn't deter too many mortgage investors over the first quarter of the year. Although prepayment activity increased, mortgage bonds remained less risky than corporate bonds, so investors saw them as a safe haven. Over the 1-year period ending March 31, 2001, mortgage-backed securities returned 12.6 percent.

¹A statistical measure of the variability of securities returns. The higher the standard deviation, the riskier the security.

Diversified Bond Funds

Most investors don't have a long list of bond sector funds to choose from in their employer-sponsored retirement plan, and even if they did, it may be better for them to simply purchase a diversified bond fund. Investors should look for a fund that benchmarks itself to a common bond index (such as the Lehman Aggregate), has an average duration close to that of the benchmark, and doesn't invest too much in non-benchmark sectors (i.e., high-yield bonds, emerging market debt, etc.) in an attempt to beat the benchmark.

The Lehman Aggregate, for example, is 100-percent investment-grade, and is composed of approximately 25 percent Treasury bonds, 35 percent agency mortgage-backed securities and 26 percent investment-grade corporate bonds. The remainder of the index is composed of other widely traded securities.

"Management fees are one of the biggest drains on bond fund returns. Several studies have shown that most bond funds generally don't beat their benchmarks over the long-term when fees are factored in." — Michael Trovato, analyst at mPower Advisors, L.L.C.

Municipal Bonds

Municipal bonds are tax-free at the federal level, and sometimes state and local levels. It's generally not wise to invest in municipal bonds within a tax-deferred account, since you already have a tax advantage in the tax-deferred account and municipal bonds generally pay lower rates than other bonds.

Fees and Risk

Management fees are one of the biggest drains on bond fund returns. Several studies have shown that most bond funds generally don't beat their benchmarks over the long-term when fees are factored in.

A 1999 study by the Securities and Exchange Commission found that the average bond fund charged management fees of 0.80 percent. If the average bond fund returned 7 percent over the last 10-year period, one can imagine how this expense ratio could significantly impact long-term returns. Comparing a bond fund's fees to this average fee may be a good guideline for determining if a fund is expensive.

One way to reduce fees is by investing in an index fund. Index funds try to replicate the structure of their benchmarks and closely track the return and volatility characteristics of the benchmark. Since the management process entails a buy-and-hold approach with low transaction costs, index funds generally have lower fees than actively managed funds.

Related Reading The Value of Asset Allocation The Longer They Are, The Harder They Fall Hal's Hints for Selecting a Mutual Fund Wall Street 201 - The Anatomy of Bonds

Just because you've invested in a bond fund does not mean you're free from risk. Many bond investors make the mistake of concentrating only on returns. In many cases, funds that have high returns also are high risk.

This risk can be found in many forms, as bond managers often seek extra yield through more volatile securities such as high-yield bonds, emerging market debt, foreign bonds, risky derivatives, or even equity securities. They may also make large bets in the portfolio, such as dramatically increasing duration to take advantage of a possible fall in interest rates. When analyzing a bond fund, volatility (risk) is just as important as return. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Field Guide to Bond Funds

By Michael Trovato
Analyst, mPower

In This Story What is a Bond Fund? Prices, Interest Rates and Duration Treasuries Corporate Bonds Mortgage Bonds Diversified Bond Funds Municipal Bonds Fees and Risk

Although unfortunate for many, the stock market's tumble may have been a blessing in disguise. Many investors moved blissfully through the 1990s believing their portfolios would double each year, ensuring them an early retirement and a stately mansion. "Why not load up on technology stocks?," they wondered. "Bonds? Who needs 'em?"

Everyone knows what happened next. During 2000, the S&P 500 fell over 9 percent and the technology-heavy NASDAQ got creamed to the tune of a 39 percent loss. Meanwhile, the bond market had its day in the sun, cruising to an 11.6 percent return, as measured by the Lehman Brothers Aggregate Bond Index.

minute: read this article at a glance.

Technical Terms Benchmark Index fund Interest Risk Sector Volatility

The lesson to be learned from this is the importance of keeping a balance of investments in your portfolio. Diversification was not a sexy topic for investors who saw massive returns in their technology funds during the 1990s and poured even more money into them as a result. Now that those funds are hurting, diversification is in vogue, and bonds have become interesting again.

So you may want to know: What is a bond fund? Should I buy short-term or long-term funds? Which bond sectors fit into my investing strategy? What fees should I expect?

Here are some guidelines to help you understand bond fund basics.

What is a Bond Fund?

A bond is a debt security, similar to an IOU. When a bond is purchased, the investor is lending money to a government, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay the bond owner a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures," or comes due.

"Diversification was not a sexy topic for investors who saw massive returns in their technology funds during the 1990s and poured even more money into them as a result. Now that those funds are hurting, diversification is in vogue, and bonds have become interesting again." — Michael Trovato, analyst at mPower Advisors, L.L.C.

The basic bond types are: U.S. Treasuries, municipal bonds, corporate bonds ("corporates"), mortgage and asset-backed securities, federal agency securities and foreign government bonds. Of these, U.S. Treasuries, corporates and mortgage securities make up most of the core domestic bond market.

A bond fund is a mutual fund that invests primarily in one or a combination of these types of bonds.

Prices, Interest Rates and Duration

Between the time that a bond is originally issued and the day it matures, its price in the marketplace will fluctuate according to changes in market conditions. This is particularly important for bond funds, as most mutual fund managers do not hold all bonds until maturity.

Bond prices are most susceptible to changes in interest rates. When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues. That's because investors want the best rate available in the market. When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues. The degree of the price change depends on the bond's duration.

Duration is the key measure of bond risk. It measures how sensitive a bond is to changes in interest rates. Long-term bonds are more sensitive to interest rate fluctuations than short-term bonds, and typically have higher durations.

Longer duration bonds typically yield more than short duration bonds, because investors demand higher return for the increased volatility that comes from the higher sensitivity to interest rate fluctuations. Does the higher yield mean you should invest everything in long-duration bonds? Definitely not.

The example below shows the risk/return tradeoff for extending a bond's duration. The investor is rewarded 3.5 percent more in return, but in order to get those gains, her portfolio experiences nearly five times the volatility. The numbers confirm what many studies have shown — that investing in longer duration bonds means taking on a disproportionate amount of risk.

You should know the duration range of a bond fund before you invest in it. This information is typically found in the fund's marketing material, and is sometimes indicated in the title of the fund. Short-term funds will typically be in the 1-3 year duration range, intermediate-terms hover around 3-7 years, and long-term bond funds will have average durations longer than seven years.

In addition to duration, many funds focus on particular bond types and invest in one particular sector or combine sectors to increase returns and reduce risk. The main sectors are Treasuries, corporate bonds and mortgage bonds. You can also find diversified funds.

Treasuries

Treasury securities are issued by the U.S. Department of the Treasury and are backed by the U.S. government. The U.S. government is regarded as the most creditworthy entity in the world, and Treasuries carry the highest rating (AAA+) by Standard & Poor's. With over $5.7 trillion in outstanding debt, Treasuries are widely viewed as safe and liquid securities. You can invest in them either individually or through a bond fund.

Due to their superior credit quality, government bonds pay lower yields than mortgage or corporate bonds with similar durations. They are often the target of investors' "flight to quality" during volatile times and are purchased as a "safe haven." Consequently, they tend to perform well when the remaining bond or stock markets begin to stumble.

Government bonds returned 12.3 percent over the year ended March 31, and the volatile equity markets were only half the reason for their outstanding performance. The returns were also assisted by a unique supply and demand situation that developed early last year.

A booming economy during the 1990s generated large tax revenues, which led to a government budget surplus. That change fostered speculation that the popular 30-year Treasury bond was near extinction: Why would the government borrow when it didn't have to?

The Treasury did follow through with a buyback program, and bought (or "retired") expensive, long-term issues that paid high coupons and also cut back in new 30-year bond issuance. The resulting supply reduction coupled with speculation that these securities would disappear led bond managers to dramatically bid up prices. Those who had a lot of Treasuries in their portfolios enjoyed a great year as a result.

Corporate Bonds

For higher returns, investors who are willing to undertake more risk can choose corporate bonds. Corporate bond investors basically lend their money to companies in exchange for its return at a later date and regular (usually semiannual) interest payments. The corporate bond market totals $3.4 trillion.

Corporate bond investors should be familiar with the bond-rating system, which evaluates issuers' creditworthiness, or likelihood that they will pay back their debts. Securities (or funds) with a BBB or higher rating by Standard & Poor's, Fitch, or Duff & Phelps, or Baa or higher by Moody's, are considered investment grade. Bond ratings below this threshold are considered high yield or "junk" and are considered much more speculative.

Bond fund managers will typically invest in a wide range of credits, focusing on the higher-tier credits when the economy struggles, and taking on more risk during economic surges by investing in lower-grade bonds. Before investing in a bond fund, you should know its average credit quality and to what degree its management is able to invest in lower-tier credits. You can find this information in the prospectus.

High-yield bonds had a miserable year in 2000, as they tend to have a high correlation with the stock market. Investment-grade bonds, on the other hand, rallied as many bond investors made a "flight to quality." Over the year ending March 31, 2001, investment-grade bonds returned 12.2 percent compared to 2.5 percent for high-yield bonds.

Mortgage Bonds

Perhaps the most complex securities in the core bond universe, mortgage bonds come in many different structures. Typically, they are pools of mortgage loans that are resold to the public. These securities are offered by a U.S. government agency (Government National Mortgage Association, or Ginnie Mae) or government-sponsored agencies (GSEs) such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

These agencies have very strong credit histories, and investors who buy mortgage bonds take on virtually no credit risk. The risk for mortgage bonds, however, lies in what is known as prepayment risk.

Like most bonds, mortgage securities pay interest on the loan in the form of coupon payments, but investors also receive repayments of their principal in increments over the life of the security. The rate at which mortgage investors receive their principal depends on the level of refinancing activity by homeowners.

Mortgage securities are typically superior performers in stable interest rate environments, but when interest rates fall, homeowners often refinance their mortgages by prepaying their original loans. This prepayment cash flow crimps returns to mortgage bondholders, who are forced to reinvest the money at lower rates. To compensate for this risk, mortgage-backed bonds typically pay higher interest rates than Treasuries.

Recent rate cuts by the Federal Reserve Board didn't deter too many mortgage investors over the first quarter of the year. Although prepayment activity increased, mortgage bonds remained less risky than corporate bonds, so investors saw them as a safe haven. Over the 1-year period ending March 31, 2001, mortgage-backed securities returned 12.6 percent.

¹A statistical measure of the variability of securities returns. The higher the standard deviation, the riskier the security.

Diversified Bond Funds

Most investors don't have a long list of bond sector funds to choose from in their employer-sponsored retirement plan, and even if they did, it may be better for them to simply purchase a diversified bond fund. Investors should look for a fund that benchmarks itself to a common bond index (such as the Lehman Aggregate), has an average duration close to that of the benchmark, and doesn't invest too much in non-benchmark sectors (i.e., high-yield bonds, emerging market debt, etc.) in an attempt to beat the benchmark.

The Lehman Aggregate, for example, is 100-percent investment-grade, and is composed of approximately 25 percent Treasury bonds, 35 percent agency mortgage-backed securities and 26 percent investment-grade corporate bonds. The remainder of the index is composed of other widely traded securities.

"Management fees are one of the biggest drains on bond fund returns. Several studies have shown that most bond funds generally don't beat their benchmarks over the long-term when fees are factored in." — Michael Trovato, analyst at mPower Advisors, L.L.C.

Municipal Bonds

Municipal bonds are tax-free at the federal level, and sometimes state and local levels. It's generally not wise to invest in municipal bonds within a tax-deferred account, since you already have a tax advantage in the tax-deferred account and municipal bonds generally pay lower rates than other bonds.

Fees and Risk

Management fees are one of the biggest drains on bond fund returns. Several studies have shown that most bond funds generally don't beat their benchmarks over the long-term when fees are factored in.

A 1999 study by the Securities and Exchange Commission found that the average bond fund charged management fees of 0.80 percent. If the average bond fund returned 7 percent over the last 10-year period, one can imagine how this expense ratio could significantly impact long-term returns. Comparing a bond fund's fees to this average fee may be a good guideline for determining if a fund is expensive.

One way to reduce fees is by investing in an index fund. Index funds try to replicate the structure of their benchmarks and closely track the return and volatility characteristics of the benchmark. Since the management process entails a buy-and-hold approach with low transaction costs, index funds generally have lower fees than actively managed funds.

Related Reading The Value of Asset Allocation The Longer They Are, The Harder They Fall Hal's Hints for Selecting a Mutual Fund Wall Street 201 - The Anatomy of Bonds

Just because you've invested in a bond fund does not mean you're free from risk. Many bond investors make the mistake of concentrating only on returns. In many cases, funds that have high returns also are high risk.

This risk can be found in many forms, as bond managers often seek extra yield through more volatile securities such as high-yield bonds, emerging market debt, foreign bonds, risky derivatives, or even equity securities. They may also make large bets in the portfolio, such as dramatically increasing duration to take advantage of a possible fall in interest rates. When analyzing a bond fund, volatility (risk) is just as important as return. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.