Know When to Bail on Your Bond Fund

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Many bond funds have enjoyed terrific returns during the past decade, and investors have been pouring money into them. But now the good times may be ending, so it will pay to look for three warning signs when picking a bond fund.

Bonds have done well in recent years because interest rate were falling, causing bond prices to rise. Think of it this way: investors will pay more for an older bond yielding 8% than for a newer one paying 4%.

Now the process is likely to reverse. Bond yields are so low it’s far more likely they’ll go up rather than down, making the older, stingier bonds less appealing and causing their prices to fall. Your interest earnings from a bond fund could be wiped out by falling values of the bonds in the fund.

But many investors still benefit from bonds, which help diversify a portfolio, or even out performance when stocks do poorly. So three considerations deserve special attention:

Duration. This is a statistical measure of a bond fund’s sensitivity to changes in prevailing interest rates. It takes some complicated math to figure duration but, fortunately, fund companies do that for you. Using the figure is easy.

Duration is expressed in years. A five-year duration means the fund will lose 5% of its value for every percentage point rise in prevailing interest rates. If rates rise three points, the fund will lose 15%, for example. A 10-year duration means the fund would lose 10% for every point rates rise, and so forth.

When interest rates are likely to rise, as they are now, it’s safer to invest in bond funds with shorter durations — two or three years rather than eight or 10.

High Yields. Investors hungry for income often look for funds with especially large yields. But yield is an indicator of risk. Any interest-paying investment that yields substantially more than average must carry some extra risk.

High-yield bond funds, for example, invest in corporate bonds with below-investment-grade ratings. In other words, ratings firms and investors think there’s a higher-than-normal risk the companies that issued the bonds will fail to make the interest and principal payments they promised.

As with long-duration funds, those with especially high yields can suffer losses from price declines that more than offset interest earnings.

Focus on the “SEC yield,” which is an average of a fund’s yield during the past 30 days. It’s more up-to-date, and more reflective of what you would earn now, than the “trailing 12-month yield,” which is an average for the past year.

High Fees. When yields and returns are likely to be low, investors should be especially careful about fees. A one percentage point expense ratio would devour 25% of your earnings on a fund yielding 4%. Fees tend to be much lower on index-style bond funds than on actively-managed funds.

Also, some experts warn that managers of high-fee funds are more inclined to take risks in hopes of offsetting fees.

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