Mutual Funds: Picking the Best Bond Mutual Fund

Why Choose Bond Funds?

Before the discussion gets around to picking the funds, start with the reasons to invest in a bond fund. Bond fund investors usually buy funds for one of the following reasons (or something close to one of these reason):

• The investor is not happy with bank CD interest rates and wants a higher yield. This investor wants his principal to stay safe, but must have that higher yield. This investor may be living off the interest or dividends from his investments.

• The investor is yield crazy. She looks through the bond fund listings and picks out the ones with the highest current dividend yields. Why settle for four percent a year in a government bond fund, when this one high yield fund is paying ten percent?

• The investor is looking for a total return, which is diversified away from the stock market. This investor would like a decent yield, but a stable or increasing share price over time is of higher importance. This is the “professional” approach to bond fund investing.

Although the third reason is probably the best rationale to buy a bond fund, investors with the other two objectives can find funds which meet their investment criteria. The challenge is to make sure the fund performs as expected.

Why Investors Buy Bond Funds

Selecting an appropriate bond fund requires applying a few principles which allow an investor to narrow the choices and select the best bond mutual fund appropriate for his investment goals. These principles assume the investor has a basic understanding of the different types of bonds: government, municipal and corporate bonds.

Principle One: Bond fund share prices will go down when interest rates increase. This risk is reduced by buying bond funds holding short or intermediate term bonds. The trade-off for principal safety is a lower yield. This risk is the downfall of the bond fund investor who buys a government bond fund for safety but picks a fund holding longer term bonds for the higher yield. When rates increase the fund share price declines significantly, leaving the investor wondering what went wrong. The interest rate risk of a fund can be determined by looking up the average duration or maturity of the fund’s portfolio.

Principle Two: High yield means low credit quality. High yield bond funds make those yields by owning non-investment grade bonds. These bonds have a significantly higher risk of default than investment grade bonds. Bond funds are probably the best way to invest in the high yield market, letting professional money managers pick the bonds. However, an investor must be aware of the higher level of risk. A high yield fund can go along for years earning investors excellent returns. However, the breakdown of high yield bonds tends to happen rapidly in times of economic recession.

Principle Three: Bond fund expenses matter. A higher bond fund expense ratio directly reduces the dividend yield of the fund. Consider two funds with similar duration and credit quality. One fund has expenses of one percent and the other a half percent. The fund with lower expenses will yield a full half-percentage point higher. On a $100,000 bond fund account, that is an extra $500 in dividend earnings every year. There must be very compelling reasons to select a bond fund with higher expenses than the 2010 national bond fund average of 0.72 percent.

Mutual Fund Companies

For the investor looking to use the principles outlined above to find bond mutual funds that fit her investment goals and critieria, the place to start is with the mutual fund families. These fund families have a range of bond funds to fit different needs as far as bond type, quality and duration.

• Pimco Investments: Pimco is to bond funds what Fidelity is to stock funds, only on a global basis. The Pimco Total Return Fund is the world’s largest bond fund. The company did not get this big in bonds by doing a bad job for investors.

• Vanguard: For investors who live by the mantra of low expenses, Vanguard offers almost 30 bond funds with names that make it easy to figure out the bond type and maturity range.

• Thornburg Investments: The eight or so Thornberg bond funds have been managed with a primary goal of the stability of investor values. The funds have long track records in both the municipal and government bond sectors. Thornburg funds are load funds sold through brokers. The sales charges are low and if you have a significant amount of money to invest in bond funds, have a broker or investment rep show you the information on the Thornberg bond funds.

Top Choices for Investors

The different financial magazines and websites like to come out with regular lists of the best bond mutual funds for this or that. Here are a few recent selections for places like Money magazine, Kiplinger and U.S. News Money. The funds cover the range of bond fund types.

• Vanguard Intermediate Term Tax Exempt
• DoubleLine Total Return Bond Fund
• Dodge and Cox Income Fund
• Harbor Bond Fund
• TCW Total Return Bond Fund
• T Rowe Price International Bond Fund

Always review a bond fund for credit quality, bond duration and expense ratio. These rules allow you to select the best bond fund to meet your investment goals.

Resources

Investment Company 2011 Factbook, Chapter 5

Money 70: Best Mutual Funds and ETFs, 2011

U.S. News Money: 100 Best Mutual Funds for the Long Term