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Bond Fund Primer: Part One – Evaluating a Bond Fund

 Individual investors have made drastic shifts to their portfolio allocations over the past year. A flight-to-quality has had many pouring assets into bond mutual funds. Bond funds have seen record asset inflows and currently manage $1.97 Trillion or 18.5% of a $10.6 Trillion industry which includes all equity and money-market funds. Since December ’08, taxable bond fund assets have risen over 26% while muni-funds have increased over 24%.

Investors should do their homework before investing in a new bond fund. There are various factors to understand and hidden risks to uncover before proceeding. Part one of this two-part primer will demystify the process by defining common bond fund terms for individual investors to consider.

Demystifying the Process

The first thing investors should do before digging through fund listings is to define their specific investment objectives. An investor should look at their entire portfolio and pinpoint the desired market exposure from purchasing a new fund. If you already own three long-core bond funds, adding another one to your portfolio won’t do you any good. One of the major mistakes investors make is buying more than one fund with a similar style of investing. You may think this provides manager diversification but more often than not, doing so will leave you over- or under- exposed to an asset class and subject to additional management fees. Choose one fund per style and class, make the best choice, and review your holdings annually. Next, please define your tolerance for credit and interest rate risk – the two main risk factors in bond fund investing. Doing so will help immediately filter the number of choices and allow you to achieve your investing objectives.

Reading and interpreting a fund’s characteristics

Initially, investors will notice a plethora of characteristics when looking at a fund’s listing. It is important to know how to interpret these characteristics as they will have a significant impact on your risk exposure, fees, and future return.

The basics:

-Fund Category: This defines the fund’s investment category based on a portfolio manager’s core holdings. It is important to closely consider the category as you look to build a diversified portfolio. The first thing to notice is whether the fund is taxable or tax-exempt. This is generally determined by the class of securities the fund holds – municipal funds may be tax-exempt while all others are generally taxable. Funds may be sector-specific, such as government, corporate, mortgage, or international in the taxable category, or state-specific in the tax-exempt category. This is the largest factor in determining your credit-risk exposure. Lastly, consider the maturity-range for the fund. Ranges include short, intermediate-term and long-term. This will categorize the level of interest-rate risk for the fund.

– Short-term government fund = taxable, has virtually no credit-risk and limited interest-rate volatility.
– Intermediate-term high-yield fund = taxable, has considerable credit-risk exposure and medium interest-rate volatility.

-Load: A fund may or may not charge a “load” fee. An upfront load is a fee the fund manager charges investors on their initial investment. It is generally denoted as a percentage of your initial investment amount. Funds may also have a back-end load, which is one that is charged upon redemption. It is preferable to own a “no-load” fund.

-Expense Ratio: Annual fee that all funds charge shareholders which will be deducted from the fund’s assets. Expense fees can range quite considerably. Generally, as I am evaluating funds and narrow them down to a handful of finalists, it is the expense fees that are the final determining factor on which fund to purchase. Over time, high fees will erode your investment performance. Actively managed funds usually have higher fees than indexed funds.

-Turnover percentage: This metric informs investors on how much the fund’s assets turnover on an annual basis. In simpler terms, it shows whether the fund has a “buy-and-hold” or a “trading” strategy. Generally funds that actively trade incur larger transaction fees.

Taken together, the factors above help investors categorize the overall strategy and risk level of a bond fund. However, these factors alone do not provide an adequate picture for making an investment decision.

Next steps:

Once you have found some funds that fit your initial investment criteria, it is critical to understand what the fund owns and how they manage their assets. We will cover these steps in Part 2 of the Bond Fund Primer.

Disclosure: None