Picking a Bond Fund That Won't Wilt

Our scoreboard shows which have the best return for the least risk

For the past few years, bonds have had more fun. While stock markets throughout the world have plummeted this year, taking the average equity mutual fund down 15%, bond mutual funds remain relatively prosperous. Taxable bond funds are up 1.8%--and returns from tax-free bond funds are out of sight, up 5.7%.

Still, those are just averages. To find a good bond fund, you should compare it with its peers. That's just what BusinessWeek's Mutual Fund Scoreboard, which can be found at www.businessweek.com, does. The scoreboard grades more than 1,600 bond funds from A to F based on their five-year risk-adjusted returns. The 7.5% of funds that receive As got them because they've earned the highest return for the amount of risk they took with your money. In addition to an overall rating, the scoreboard has a category rating that compares bond funds against others of the same investment style. An A in both is the ideal buying situation.

Right now, many of the funds with overall A ratings are those that invest in bonds with short maturities--less than three years. Such bonds benefited from a significant steepening of the yield curve over the past three years, as short-term interest rates fell much more sharply than long. (When rates fall, bond prices rise.) "Long-term rates have stayed fairly high because people believe we are going to see an economic recovery," says Lyle Fitterer, portfolio manager of the A-rated Strong Short-Term Municipal Bond Fund (STSMX ). "That could cause inflation to rear its ugly head." After all, no one wants to lock up their money in a 30-year bond with a 6% yield if inflation could rise to 6% and eat their return.

The Federal Reserve usually raises interest rates to cool the economy and fight inflation--and that causes all bonds to fall in price. But all other things being equal, short-term bonds take less of a hit than intermediate and long-term issues. That's because investors will get their principal back sooner--money that will be reinvested at higher rates. As such, short-term bonds and bond funds tend to be less volatile than their long-term cousins.

Short-term bonds don't yield much now. A three-year Treasury note yields 2.6%, a three-year top-rated corporate upward of 4%--not a lot of bang for your buck, especially if you consider that a mutual fund will take a good chunk of that yield as its management fee.

Fees are always important, but since yields are so low right now, they take on special significance. A fund yielding 5% before deducting a 1% expense ratio loses 20% of its yield to fees. So low-cost fund families such as Vanguard Group, TIAA-CREF, and Fidelity Investments have a definite edge. "We put 95% of our assets in investment-grade bonds, and we still deliver higher yields than other muni funds because of our expense advantage," says Christopher Ryon, manager of A-rated Vanguard Intermediate Term Tax-Exempt Fund (VWIUX ). Indeed, the fund's 0.19% expense ratio is less than one-fifth the 1.07% average for municipal-bond funds.

So if you want both yield and safety, you'll have to do some legwork and look in some unusual places. One A-rated short-term bond fund currently yielding a healthy 4.4% is the Payden Global Short Bond Fund (PYGSX ). This fund by prospectus must invest at least 75% of its assets in investment-grade bonds rated BBB or higher, so it doesn't take on too much credit risk. Many of its government bonds come from "transition countries that have just been rated investment-grade," says portfolio manager Laura Zimmerman. Among the nations newly rated investment-grade are Hungary and South Korea.

If you want to stick close to home but still seek higher yields, you could invest in longer-term bond funds. Vanguard Intermediate-Term Tax-Exempt Fund has an average maturity of just six years and delivers a 3.5% tax-exempt yield, which is the equivalent of 5% after taxes for investors in the 30% income-tax bracket. But you don't want to go out too far in maturities. Vanguard Long Term Tax-Exempt Fund (VNJUX ), with an average maturity of 10.3 years, yields just 4.1%, not much extra income for a lot more interest-rate risk.

Another alternative for yield-hungry investors is to take on more credit risk. That's how high-yield bond funds work, investing in securities with debt ratings below BBB. This sector takes more of its cues from the stock market than the bond market, and not surprisingly, it's the only sector of the bond market to be in the red so far this year. No high-yield bond fund receives an overall A rating, but there are funds that earn As when compared with other high-yield funds. Among them are Columbia High-Yield (CMHYX ), EquiTrust Strategic Yield (FBYBX ), and Strong Short-Term High Yield Bond (STHYX ).

Scoreboards have their limitations. They are purely numbers-driven, and numbers don't tell all. You still need to do some basic research. Go back to the three high-yield funds. Jeffrey Koch, who ran Strong Short Term High Yield Bond for five years, recently left Strong, prompting two leading fund advisory firms to pull their recommendations. That may not be enough reason to sell the fund if you own it, but it's enough to avoid making a new investment. EquiTrust's fund has a 1.94% expense ratio, higher than the 1.28% average for the category. True, the fund has still been able to achieve a top rating despite its overhead, but high costs can eventually weigh a bond fund down. So, of the three, Columbia High-Yield is the best option.

At the Columbia fund, portfolio manager Jeffrey Rippey sticks to the sector's better-quality bonds. "Our whole pitch is high-quality high yield," he says. "We buy BB-rated bonds that we think can be upgraded to investment grade." Such upgrades open the door to institutional investors who are restricted to owning only investment-grade bonds; their buying drives the bond prices up. This strategy has delivered a 4.8% five-year annualized return, vs. 0.2% for the average high-yield fund. The fund now yields 8%, less than most of its peers. And that's O.K. With the economy slow and many big borrowers looking shaky, safety should come before yield.

By Lewis Braham

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