How to invest wisely in a bond fund

Nation's Business, March, 1996 by Randy Myers

Retired newspaper manager Mike Middlesworth of Hilo, Hawaii, prizes safety in his investment portfolio. So it's not surprising that he has invested half of his retirement nest egg in bonds, which typically provide smaller returns than stocks but also carry less risk.

What might surprise some investors is that Middlesworth has put the bulk of his fixed-income portfolio in mutual funds rather than individual bonds.

Many savvy investors disdain bond funds because they lack one of the key features that make bonds distinctly different from, and generally safer than, stocks in the first place: the promise that they will pay a specified rate of interest and will be worth precisely what you paid for them when they mature (assuming the issuer doesn't default).

Investors who prefer U.S. Treasury bonds particularly dislike bond funds because their operating expenses chew up part of the interest income that bonds generate. (You can buy Treasury bonds directly from any of the Federal Reserve's 12 banks or two dozen branches throughout the country without paying any fees.)

The average bond fund, in addition to being saddled with operating expenses, holds a constantly changing collection of securities that together provide neither a fixed yield nor a fixed maturity date. That means there's no precise way to predict what your shares will be worth after a specified period of time or how much interest your fired rill generate.

Results can vary dramatically In 1994, one of the worst years for bonds, the average domestic bond fund posted a loss of 3.26 percent as interest rates rose. (Bond prices fall when interest rates rise.) Last year, as interest rates declined, the average fired gained 15.22 percent. This year, economists expect interest rates to be stable to slightly lower, meaning bond funds most likely will post moderate gains at best.

Despite their drawbacks, bond funds appeal to Middlesworth and many other investors, who together hold about $600 billion in more than 3,000 bond funds, according to Morningstar Inc., a Chicago-based research firm.

"I don't want to have to deal with individual bonds," says Middlesworth, echoing a common theme. "Creating a laddered portfolio of bonds," or bonds with successively longer expiration dates in order to diversify exposure to interest-rate changes, "is more work than I want to do. I may give up a little yield, but my fund company does all the work for me."

If you're interested in finding a bond fund for your portfolio, start by assessing the different types of bonds in which funds can invest. Bonds vary principally by the length of time until maturity and by the type of issuer.

Longer-term bonds react with more volatility to interest-rate changes than do shorter-term issues,' so they're considered more risky. U.S. Treasury bonds carry less risk than those issued by corporations and municipal governments because they are backed by the full faith of the U.S. government.

The longer a bond's term, and the weaker the financial strength of the issuer, the higher the rate of interest the bond must pay to attract investors.

Once you understand how bonds work, you can pick a fund whose investment style is suited to your objectives and your tolerance for risk. If you're an aggressive, long-term investor seeking to build wealth, you may want a fund that specializes in long-term securities, perhaps corporate bonds. If you're more averse to risk, choose a fired that invests in long-term Treasuries or intermediate-term issues.

If your investment goals are short-term--perhaps you're saving for a new car or a down payment on a house, or merely want to generate a steady income stream--stick to shorter-term bond funds that won't be buffeted as badly by interest-rate changes.

In addition to weighing your investment goals and tolerance for risk, evaluate your tax position if you are investing outside a tax-deferred retirement account.

If you are in a high income-tax bracket, consider a fund that invests only in municipal bonds. Although municipal-bond funds pay less interest than taxable bonds, your net return could be higher. This is because the interest income on these bonds will be exempt from federal income taxes. If the fund invests only in muni bonds issued in your state, you will be exempt from state taxes, too.

Once you have decided what type of fund you want, shop carefully. Unlike money-market funds, whose performance can be judged primarily by the rate of interest they're paying, bond funds must be evaluated based on their total return--yield plus price appreciation. Look for a fund with a respectable total-return record and low operating expenses. More than anything else, low expenses are what make a bond fund a top performer in its category. "Bonds are almost like commodities, so the amount of fees you pay can really lower your return," explains Mary Merrill, a financial adviser in Madison, Wis.

Merrill and other investment advisers widely credit the Vanguard Group for offering bond funds with the lowest expense ratios in the industry--an average of 0.22 percent of assets as of Nov. 30, compared with 1.0 percent for all bond funds.