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For the novice
investor, picking a new bond fund entails a daunting search through hidden
costs, skimpy disclosure and otherworldly jargon, all for the right to
plunk down money for a small payoff that can fall far short of stocks.
This pursuit is that much more perilous as an era of low interest rates
ends, pushing prices down and hurting bond portfolios.
But bond beginners must summon the courage to
proceed, for keeping a well-balanced investment lineup requires that they
understand and own bond funds. Bonds can offer a steadying hand to a
portfolio (provided interest rates aren't going haywire). Bonds check, and
sometimes counteract, the stock market's volatile ups and downs. When
stocks suffer, it can be comforting to turn to your bond stash and see it
slowly, steadily gaining. As a bulwark to preserve capital, bonds can give
you peace of mind to take on greater risks with other investments.
The simplest path: Best Buy funds, based
largely on the fact that they take so little from you in fees. The list
includes the Vanguard Short-Term Bond Index Fund, which charges 18 cents
per $100 invested, and bans such costly culprits as the Calvert Income
Fund, which charges seven times as much--$1.20 on $100, plus a sales load
of 3.75% of assets.
Raw cost is just one of several criteria that
count. So we have added a greatest-hits list that considers costs but also
three other measures; one assumes that interest rates will continue their
rise. The extra factors:
Turnover: Be wary of
funds that churn holdings at a fast pace. Rapid trading,
indicated by turnover rates of 100% or higher, invisibly saps a
fund's
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assets. Each trade exacts a commission, and these trading costs aren't
wrapped into the expenses that a fund discloses--the first, best gauge of
how well a fund manager cares for your money. Nor do funds have to report
their trading costs to the Securities & Exchange Commission as stock
mutual funds do, because the commissions are tucked into the price of the
bonds. So turnover is a way to estimate the costs of all that trading.
High turnover also can raise the risk that you might get zinged with taxes
on capital gains--a moot point if the fund is in a 401(k) or similarly
tax-deferred account.
Duration: Shorter is
better. This is lingo for the vulnerability of a bond's price
to interest rate swings. In most cases it measures how long it takes for
you to rack up enough interest to earn back a bond's purchase price. Never
mind whether interest rates will rise. A shorter duration is lower-risk.
The Marshal Short-Term Income Fund, with a duration of 1.3 years, will
lose 1.3% of its net asset value if rates climb one point. The Vanguard
Long-Term Investment Grade Fund, with an 11-year duration, would produce
an 11% loss.
But be warned: If interest rates fall,
shorter-duration bonds trail. A decline of one point in rates would
produce gains of 1.3% in Marshal versus 11% in the Vanguard fund. Fidelity
and other fund companies list a given bond fund's duration on their Web
sites. If it's not there, finance.yahoo.com lists a fund's duration along
with its top holdings.
Credit Quality: Avoid
funds that load up on junk. Some like to spice up returns with
high-yield bonds. But since junk carries more default risk, you need to
know what junk is in your fund and how much. But bond funds make
incomplete disclosures of their holdings. When funds list their bonds on
their own Web sites, typically they list only the largest. So check out a
fund's quarterly holdings report at the SEC site, www.sec.gov, and look
for form N-Q; the annual report is called form N-CSR. Finding a particular
fund on the site can be vexing, and the data are two months old by the
time funds report it.
Adding to the muddle, bond funds report holdings
by the specific bond issue, rather than by the company doing the issuing.
So it's possible to check a fund's biggest holdings on its Web site and
miss its modest positions in an array of different Ford Motor bonds,
recently declared junk by Standard & Poor's.
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