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Bond fund selection guidelines
Below are a few tricks of the trade when it comes to selecting the right bond fund for you.
1) Think low expenses
The single most important thing you can do to earn competitive returns in a bond fund is to opt for those with low expenses. As a general rule, bond index funds will have lower expense ratios than managed funds that invest in, say, munis and junk. With the latter, at least stick with below-average expenses.
2) Stick with short to intermediate maturities
Over the past 20 years or so, long-term bond funds have provided the highest returns, partly because interest rates have steadily declined over that period. That may not always be the case.
What's more, long-term bond funds can be surprisingly volatile. If interest rates rise just 1 percentage point, a long-term bond fund can drop 10% or more, wiping out more than a year's interest.
If you're investing for shorter periods - 10 years or less - or if you're using bond funds to add some ballast to a predominantly stock portfolio, then you may be better off with bond funds with short- to intermediate-term maturities - say, five to 10 years.
You can typically get 75 to 80% of the return of long-term funds, while incurring roughly 40% less volatility.
3) Beware tempting yields
Fund companies know that investors focus on yields. So some do everything they can short of putting the fund on steroids to pump up yields. They may throw some low-grade bonds into a government portfolio, or even invest in international bonds from countries where rates are especially high.
These ploys to boost interest may or may not pay off, but they all involve risks that are difficult to evaluate. A bond fund that's touting much higher yields than funds with similar maturities raises red flags - it's a sign that the fund is doing something much different, and probably much riskier, than its peers.
If a much higher-yielding offering can't explain its outsized yields by having ultra-low expenses, move on (or accept the fact that you're investing in a riskier-than-average fund).