Saturday, May 16, 2009

Bond Fund Breakdown

Many investors who have stayed away from bond funds in the past are now pouring money into them.  A bond fund may be riskier than you think, let’s take a look at how to break down a bond fund.  

Let me first describe want a bond is.  Simple put it is a loan.  You can loan a company, government, or government agency money (principle).  They promise to pay you back with interest (coupon) over a certain period of time.  If you hold the bond until its maturity date you will get all your interest and principle. 

Bonds carrier a risk of default and therefore have a credit rating associated with them.  U.S. Treasury bonds, bills and notes have the highest rating of AAA. The scale goes down from there and it depends on how the rating agency assigns letter ratings to determine risk.  A bond fund will breakdown how much of the fund in is each rating or give you the average rating.  

The longer the term or maturity of a bond generally the greater the risk of price fluctuations.  Bonds are traded on the open market.  If you needed to sell your bond before maturity you may sell it for a gain or a loss.  Generally speaking if current interest rates are less than your bond you can sell it for a gain, but if current rates are higher you have to discount your bond and sell at a loss.  Bond funds have a measurement called duration expressed in years.  If the duration of a bond fund is 8 years, that means a 1% rise/decline in interest rates equates to an 8 percent loss/gain all other things being equal.   

For investors currently looking to add bond funds to their portfolio consider the environment.  Current interest rates are very low and have little room to go down and we are in a recession.  When analyzing a fund look for a fund with most of its money in A rated bonds and an duration of 5 years or less.  If you want to take less risk go with a fund whose duration is under 3 years.  

Since bond funds are interest bearing instruments the expense ratio is extremely important.  There are plenty of bond funds with expense ratios under .70%.  Any higher than that and I do not know how a company can justify the cost.  

Bond funds are a great addition to a portfolio but do carry risk.  With the current economic environment do some research before jumping in. 


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