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Best bond funds

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  • Best bond funds

    Courtesy of Benzinga

    The U.S. bond market is over $40 trillion and spans the full gamut of investor profiles from safety-minded treasury buyers to risk takers rolling the dice on high-yield bonds.

    Buying stocks individually is an effortless undertaking in today’s market. Bond investing often requires a lot more work, researching and laddering bonds much like CDs that mature at different dates, which is why many investors choose bond funds.

    Managing a bond portfolio can be time-consuming for individual investors. Bond funds provide a more efficient way to gain exposure to the overall bond market or to focus on certain types of bonds.

    A bond fund works in a similar way to stock market mutual funds, wherein the fund buys the assets, the bonds, and investors buy shares in the fund itself. In most cases, bonds within a fund are not held to maturity. Instead, bond funds typically buy and sell bonds, rebalancing the portfolio according to market conditions and the fund’s investment goals. Shareholders of bond funds are paid monthly or quarterly based on income from bonds held within the fund.
    Bond fund advantages

    By some measures, bond funds are even more advantageous than stock market funds because buying individual stocks still provides an easy entry and exit. Buying individual bonds is often less efficient, with retail investors at a disadvantage to brokers and institutional investors when buying or selling. When it’s time to sell your bond investments, the bond market offers less liquidity for many individual bonds. Lower liquidity often means you may not get the price you’d hoped to get.

    Active management of bond funds means that a manager or management team screens bonds to ensure they meet the criteria of the bond fund, measuring risk by choosing bonds with certain ratings from rating agencies like Moody’s and S&P, while also analyzing time to maturity and coupon rates. Management teams for bond funds also have access to news that may affect the value of the bonds within the fund, allowing the team to react faster than the individual investor.

    Dividend payments for bond funds can often be reinvested automatically, helping to grow future returns and saving the investors the homework of choosing new bonds for investments.

    Bond funds may also benefit from better pricing on acquired bonds. Buying bonds from brokers may not come with full transparency and the spread when purchasing bonds as an individual investor can put you at a disadvantage to larger players.

    For diversification, it’s tough to beat a bond fund. Buying individual bonds can be cash-intensive, with bond denominations often thousands of dollars each, making it difficult to purchase enough bonds to be well-diversified.

    Bond fund investors have no shortage of fund options, with choices ranging from low risk to high yield, total market index funds, specialized funds, and hundreds of viable options through mutual fund companies and ETFs. Drawbacks of bond funds

    Service has a cost, which is one of the largest drawbacks to bond funds. Participation in the fund exposes investors to several fees that can take a bite out of returns, including management fees and transaction-based fees.

    Some bond funds can have higher expense ratios than stock market mutual funds, creating a headwind for investors.

    Risk can fluctuate with bond funds because the fund is constantly buying and selling bonds. Individual investors buying bonds can generally expect risk to trend downward as bonds age and approach maturity. This buying and selling activity within the fund can also make bond income as an aggregate more unpredictable.

    Additional fees associated with some bond funds include redemption fees, which may apply if you buy into the fund and then sell within a short time frame, like 60 or 90 days, and sales loads, which are fees that can be charged on the front or back end when you buy or sell a bond fund. What to look for in a bond fund

    Low expense ratio

    Ideally, the bond funds you choose won’t chew up all your earnings like a Saint Bernard puppy. Bonds aren’t like stocks and the price won’t go to the moon like Apple or Amazon, so higher expenses for bond funds can be more tangible than with stock market mutual funds. Risk/reward

    Your investment goals and risk tolerance should guide your choice in bond funds. Riskier bonds can provide a higher yield, but some of the bonds might be at risk of default. As you might expect, lower risk bonds usually don’t provide a high yield, but income from lower-risk bond funds can still be respectable, often much higher than you can earn from CDs or savings accounts. Investment grade bonds

    Bonds rated at BBB or higher are generally considered to be “investment grade”. The default rate for these bonds is very low, making them a safer investment. The alternative is “junk bonds” rated below BBB, most of which won’t default, but enough of them can go bad to erase your earnings. Tax-free income

    The income from corporate bonds and even treasuries is taxable, taking yet another bite out of your income. Municipal bonds, however, are tax-free at a federal level and if from your home state, are usually exempt from state taxes as well. Yields can be attractive for municipal bonds but watch out for riskier states and municipalities. What to watch for carefully when buying bond funds

    Leveraged bond funds

    We don’t need to go back too far in financial market history to see what can go wrong with leverage and derivatives. A leveraged bond fund that promises to triple your gains can also triple your losses. High minimum investments

    Bond funds sometimes require a significant investment. Sales loads

    Some bond funds charge a “load”, which is a fee paid at the time of purchase or at the time you sell. Redemption fees

    Some bond funds charge a redemption fee if you sell a short time after buying into the fund. ETFs avoid this problem because they trade like stock shares.
    How we chose the best bond funds

    We weighed several types of criteria in choosing the best bond funds while also highlighting bond funds forspecific types of investors or investment goals.

    Fees and expenses are always a strong consideration, with the understanding that more actively managed funds may have higher expenses. Best bond funds

    Best is a subjective term. What’s best for a younger investor or investors with a higher risk tolerance might not be best for investors approaching retirement or with little risk capital. Our bond fund roundup has something for nearly everyone, including some ETFs, which provide low expense ratios and can be traded easily without loads or redemption fees. Best for low risk: Schwab Short-Term US Treasury ETF (SCHO)

    If safety and capital preservation is your priority, Schwab’s Short-Term U.S. Treasury ETF is like money in the bank, but with a slightly better return. Don’t expect to get rich with this one.

    Instead, the fund is a way to gain exposure to short-term treasuries, which aren’t subject to state or local taxes, and to park money safely while still beating the interest rates on traditional savings accounts. With a low 0.06% expense ratio and easy entry and exit as an ETF, Schwab’s Short-Term U.S. Treasury ETF is an easy choice for risk-averse investors. Best for high yield: iShares 0-5 Year High Yield Corp Bond ETF (SHYG)

    Focused on high yield corporate bonds with short remaining maturity durations (less than 5 years), the iShares 0-5 Year High Yield Corp bond fund is another easily traded ETF.

    While not the lowest expense ratio in our roundup, the fund’s 0.30% expense ratio still leaves plenty of room for returns. This fund is designed to track the Markit iBoxx USD Liquid High Yield 0-5 Index and trades its bond assets based on that goal. Best for index investors: Vanguard Total Bond Market Index Fund (VBMFX)

    It’s difficult to find a best of breed list of mutual funds that doesn’t include at least one entry from Vanguard – and often more than one. As its name suggests, this fund seeks to track the broad bond market of investment grade bonds and invests primarily in U.S. government bonds and corporate bonds.

    Vanguard’s Total Bond Market Index Fund boasts an affordable expense ratio of 0.15% combined with an acceptable risk level because of the fund’s broad diversification. Similar funds have expense ratios 5 times higher, but there’s a cost to entry. The minimum initial investment is $3,000 for all account types. Best municipal bond fund: Vanguard High Yield Tax Exempt Fund (VWAHX)

    Combining tax-free bond investing with an attractive yield, Vanguard’s High Yield Tax Exempt Fund also strives to limit risk commonly found with higher yield bonds.

    Investors should be aware that income from municipal bonds issued by other states may be subject to state or local income tax in your own state. Muni bond income, however, is unburdened by federal taxes. Expenses are a low 0.19% and as an ETF, the fund can be bought or sold through a standard brokerage account. Best for corporate bonds: Vanguard Short-Term Corporate Bond ETF (VCSH)

    Tracking the Barclays U.S. 1-5 Year Corporate Bond Index, Vanguard’s short-term corporate bond fundbundles over 2,000 holdings to provide a diversified portfolio – and with a low 0.07% expense ratio.

    Returns are conservative, as is often the case with short-term bonds, but the fund’s investment grade bonds provide a haven for investors in the sometimes-risky corporate bond market. Best for buy and hold investors: Fidelity Total Bond (FTBFX)

    With over 2,700 bonds in the fund, Fidelity’s Total Bond Fund is well-diversified as has provided superior returns to many alternatives.

    The price of entry is $2,500 as a minimum investment and a low expense ratio of 0.45% helps to maximize returns. Final thoughts

    Bond investing on your own can be labor intensive, and mistakes are easy to make if you aren’t well versed in bonds or if you aren’t watching the news wires for details that can affect your investment. For most investors, the easiest solution is to buy a bond fund. Fortunately, today’s market offers a wide selection and bond ETFs can be just as attractive as mutual fund options.

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