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Investing in Bond Funds: Understanding the Basics

October 20, 1998|PAUL J. LIM

Before investing in a bond mutual fund, it helps to understand the mechanics of how the funds work.

Unlike a bank CD or an individual bond, which pay a set rate of interest for the life of the security, bond funds' income payments can vary. Bond funds tend to distribute the income they earn on their portfolios to investors every month. Investors can choose whether they want that income paid to them directly or reinvested in additional fund shares.

The size of a fund's income payments can change from month to month, based on what's in the portfolio at a given time.

That's one reason you'll notice that a fund's so-called SEC yield, which measures the annualized yield investors have enjoyed during the last 30 days, will often differ from its 12-month yield, which is based on the actual income distributed to investors over the past year. The yields also will vary depending on the fluctuations in the fund's share price (because yield is the per-share income divided by the share purchase price).

Still, many bond funds try to maintain a fairly steady payment stream, although if market interest rates decline over time, so will a fund's payments--as older bonds mature and newer bonds are added to the portfolio.

Before investing in a bond fund, study its annual dividend payments (included in its historical material). That will give you a sense of how the income payout has changed over time.

But in your efforts to seek out a decent yield, don't forget the inherent risks of a bond fund. A surprising number of investors believe that bond funds can't lose money. That's false.

A bond fund's principal value--your share price--will rise or fall based on changes in the value of the bonds in the portfolio. Most often, that value changes because of shifts in market interest rates: If rates fall, the value of older, higher-yielding bonds rises. But if market rates rise, older bonds with below-market yields naturally will decline in value.

That's why Greg Schultz, a principal with Asset Allocation Advisors in Walnut Creek, Calif., believes bond fund investors should focus on "total return": yield plus the potential gain or loss in principal value over time.

Other advice when shopping for bond funds:

* Check the fund's average maturity or duration. A fund's average maturity, a figure that can be found in its literature, is the number of years before the bonds in the fund, on average, are paid off.

The longer it takes for bonds in a fund to mature, the greater the potential swings in the fund's principal value--up or down--as market interest rates swing. Duration, similar to average maturity, is a statistical measure of a fund's sensitivity to rate fluctuations.

Thus, if a fund's 30-day yield is high but its average maturity is short (say three or four years, like most shorter-term bond funds), the yield on that portfolio could drop substantially if interest rates fall and the fund is forced to reinvest in new bonds with lower yields.

Notes James Stack, editor of the Invest Tech market analyst newsletter: "The shorter the maturities, the less stability on the yield you're getting."

* Beware the highest-yielding funds in a category. This is what Schultz refers to as the "yield trap." Sometimes, "generating yield is a sleight of hand" by the fund manager, Schultz said. Some funds, realizing that income-oriented investors fixate on yields, may artificially (though legally) inflate their income payouts to attract investors. As a rule, the higher the yield, the greater the potential risk to your principal value.

* Buy low-fee funds. Because bond fund returns over time tend to be well below returns on stock funds, investors must be that much more vigilant when it comes to management fees and other fund costs. Look for a fund annual expense ratio well under 1%.

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