Guide To Investment-Grade Bond Funds: Best Buys

Cost efficiency is very important. These funds deliver it.

Do you need a counterweight to a risky stock portfolio? This survey will steer you to high-grade bond funds with low fees.

Money is flooding into bond funds, and with good reason. The past half century has seen three crashes in which stocks got cut in half. We may be due for another. A collection of bonds will probably provide a cushion.

Bonds, to be sure, have their own problems. Coupons are terrible. Principal would be damaged by a run-up in interest rates. With the limited exception of certain Treasury securities, bonds provide no protection against inflation.

But these two hazards are different from the hazards of the stock market, and so it makes sense use them to spread your risks. The classic recommendation for a retiree is a blend of 60% stocks and 40% bonds.

This guide covers 29 mutual funds and 55 exchange-traded funds that hold portfolios of what are known in the trade jargon as “investment grade” bonds. That means bonds rated BBB or better. Defaults are fairly rare in this corner of the bond market.

You have to make two big decisions when you buy a bond fund:

—How far out are you willing to reach in maturity? The further you go, the better the yield, but the greater the risk. Long-dated bonds are volatile. Their prices go up the most when rates fall, such as in the first half of 2020, and down the most when rates rise.

—How far out are you willing to go on the quality spectrum? Lower-rated bonds pay more interest, but they are at greater risk of default.

These tables make the choices clear. The funds are sorted by maturity, with the short-duration ones at the top. Credit ratings range over the four notches from BBB to AAA.

Conspicuously missing here: any citation of past returns. There are two reasons for the omission.

One is that past performance is a very misleading guide to the future. Consider the Vanguard Extended Duration Treasury fund, ticker EDV in the list of triple-A ETFs. So far this year it has delivered a total return of 32%, a consequence of the collapse in interest rates. That performance number says nothing about what you can expect from this portfolio. The best estimate of future returns is the yield on those long Treasury bonds, now only 1.4%.

The other reason for disregarding past results is that portfolio managing skills have so little impact here. An ability to sort good companies from bad might enable a manager to beat the stock market average, or to overtake peers with junk bonds, but it’s not going to do much for bonds likely to pay off in full. My Microsoft 3.7s of 2046 behave much like your Oracle 3.6s of 2050.

An illustration of the point comes from Baird Aggregate Bond, a diversified mutual fund whose 0.3% expense ratio, while not bad, puts it out of the running for our tables. Morningstar heaps praise on this fund, citing “incentives to encourage career development among younger analysts” who “add value through sector rotation and security selection.”

And what value did they deliver? The fund has averaged a 4.72% total annual return over the past decade. That’s good, but the number is largely a function of two choices made not by the analysts but by the customers: the duration and credit quality of the fund.

Compare Vanguard Intermediate-Term Bond Index, which almost matches the Baird fund in duration and credit quality and boasts of no clever analysts. Its average return was 4.76%. Same end point, less sound and fury.

These Best Buy tables point you to products like that Vanguard index fund. To get on the list, a fund has to have an average credit quality of BBB or better, assets of at least $50 million and an expense ratio no worse than 0.1%. Mutual funds must be no-load; ETFs must have a daily trading volume above $1 million.

“Duration” is defined as the average waiting time to receive money with a present value of $1. It’s rather like the time to maturity, but it does a better job than maturity in measuring the impact of interest rate jumps. The price of a bond with a duration of ten years will go down 10%, more or less, on a one-percentage-point rise in rates.

Most funds keep their durations constant over time, replacing a ten-year bond that has matured with a new ten-year bond. The exceptions are those target date corporate funds from iShares and Invesco, which terminate on a date certain.

Costs matter. Take a look at these crummy yields. Subtract a guess for inflation—say, 1.5%. You’re looking at a real return barely in positive territory. Don’t let that meager return get spirited away by middlemen.

Should it be a mutual (which is to say, open-end) fund or an exchange-traded one? That’s largely a matter of convenience. If you have an account at Fidelity, Schwab or Vanguard, one of the house brand mutual funds would be a fine choice. If you don’t, you’ll probably be better off buying ETFs.

For taxable accounts and for long-term holders, ETFs have advantages over mutual funds: They avoid capital-gain distributions and they push the costs of getting money in and out the door (trading costs, that is) onto restless investors. But in bond investing these advantages are slight.

Source: Guide To Investment-Grade Bond Funds: Best Buys

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