How to Choose the Best Bond Funds

Learn the Basics of Bond Funds Before You Buy

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Learn how to choose the best bond funds for your goals.. Getty Images

There are several different types of bond mutual funds on the market. But which are the best bond funds for your investment objectives?

Are you looking for income? Or are you a long-term investor looking to build a diversified portfolio? Will you hold your bond funds in an IRA, a 401(k) or a regular brokerage account? How long do you have to invest? These are some of the basic questions to answer prior to choosing the best bond funds for your investing goals.

Choosing the Best Bond Funds for Income Purposes

Bonds are categorized as fixed-income securities; therefore income is a common purpose for buying bond mutual funds. Income is another term for interest payments. For example, an individual bond will pay interest, called a coupon, to the bond holder (investor) at a stated rate for a stated period of time (term). If held to maturity, and the bond issuer does not default, the bond holder will receive all interest payments and 100% of their principal back by the end of the term.

But in the case of bond mutual funds, the mutual fund will hold dozens or hundreds of bonds and will pass along interest payments, less fund expenses, to the mutual fund investors.

When searching for the best bond funds for income, you'll want to look at the 30-Day SEC Yield, which refers to a yield calculation that is based on the 30-day period ending on the last day of the previous month.

The yield figure reflects the dividends and interest earned during the period, after the deduction of the fund's expenses.

The SEC yield is an approximate yield an investor would receive in a year assuming that each bond in the portfolio is held until maturity. But keep in mind that bond fund holdings (the underlying bond securities) are not held to maturity and bond funds do not "mature." However, the 30-Day SEC Yield still provides useful information to investors because it helps estimate income, expressed as a percentage, needed for planning purposes.

Bond funds also report the Trailing Twelve-Month Yield, or TTM, but this yield reflects the past and it may not be the same over the next year.

In the past decade, bond fund yields have been historically low, which has led to a stronger interest in high-yield bond funds. Also known as junk bond funds, high-yield bond funds carry more market risk and investors should use caution when investing in these securities.

Investing in Bond Funds for Diversification

Another common purpose for investing in bond funds is diversification. Bond prices move in the opposite direction as interest rates. So when the Federal Reserve Board signals that it will lower their interest rate charged to banks, the prices for bonds usually go higher. And the Fed usually lowers rates when the economy is weak.

Therefore bond mutual funds can perform well when the economy and the stock market are not. For this reason, many investors like to include bond funds in their portfolios to provide more balance and stability when their stock mutual funds may be falling in price.

The best bond funds for diversification are total bond market funds, such as Vanguard Total Bond Market Index (VBMFX), which seeks to replicate the returns of the Barclay's Aggregate US Bond Index, a broad bond index covering most U.S. traded bonds and some foreign bonds traded in the U.S.

Most investors seeking diversification do not look for bond funds with the highest yields; they will instead seek funds like VBMFX that cover all types of bonds at a low cost or at least funds with below-average expense ratios.

Choosing the Right Investment Account for Your Bond Funds

Since bond mutual funds are income securities, you'll want to do your best to limit the taxes on that income. For example, if you have the option, it is generally best to hold bond funds in a tax-advantaged account like an Individual Retirement Account (IRA) or a 401(k). Interest income and capital gains are not taxed while you hold the funds in these accounts. Instead the tax is "deferred" until you make withdrawals. Therefore bond funds will benefit more from compounding interest, and will thus grow faster, in a tax-deferred account.

If you want or need to hold bond funds in a taxable brokerage account, you may consider investing in municipal bond funds. Although the yields for municipal bond funds are usually lower than that of taxable bond funds, the interest from municipal bonds is free of taxes at the Federal income tax level.

And if the municipal bonds are from the state where you live, the income tax, if applicable, can be free at the state level as well. You can look for municipal bond funds that buy only municipal bonds within your state. For example, if you live in New York, you could look for New York municipal bond funds like Vanguard New York Tax-Exempt Fund (VNYTX).

Match Your Bond Funds With Your Investment Objective

We've already covered investing in bond funds for income and investing in bond funds for diversification. But you also need to be sure your investment objective, specifically your time horizon, matches the best type of bond fund.

For example, if you're looking the best bond fund that can earn interest higher than a CD or savings account at a bank, and there's a chance you'll need to withdraw some or all of your money within one to two years, a short-term bond fund or ultra-short-term bond fund could be a smart choice.

If your holding period is longer than three years, you can invest in almost any kind of bond fund that meets your other objectives, such as income or diversification.

When matching bond funds to your investment objective, be sure to remember that bond funds can decline in value. In some cases, it may be wise to not use bond funds at all. For example, if you think you'll need to withdraw money in less than one year, bond funds (or any mutual funds for that matter) are not a wise choice.