Morningstar's Bond-Fund Buying Tips

Look for low costs

A low-cost mentality is a must when evaluating funds—even more so when the funds in question buy bonds. Because bonds typically gain less than stocks over time, their costs become a heavier burden. Costs are the most important factor when evaluating bond funds, hands down.

Note that, in addition to their expenses, high-cost bond funds often take on more risk than low-cost bond funds. Expenses get deducted from the income the fund pays to its shareholders, so managers of high-cost funds often do the darndest things to keep yields competitive, such as buying longer-duration or lower-quality bonds, or complex derivatives. In doing so, they increase the fund's risk.

Managers with low expense hurdles, in contrast, can offer the same yields and returns without taking on extra risk. Plenty of terrific bond funds carry expense ratios of 0.75% or less.

Focus on total return, not yield

Yield provides instant gratification in the form of regular income checks. But chasing yield can have its costs. Some funds use accounting tricks to prop up their yields at the expense of their principal, or net asset value (NAV). Managers will pay more than face value for high-yielding bonds and distribute that entire yield as the bonds depreciate to face value. Or they'll buy undervalued bonds and supplement their lower yields with capital gains. Both practices cut into NAV.

Investors sometimes accept dwindling NAVs for burly yields because they want the regular income that yields offer. Bad idea. Yield is nothing more than a percentage of NAV, so shrinking NAV leads to smaller income checks over time.

Imagine a $10,000 investment in a fund carrying an NAV of $10 and yielding 6.5%. One year later, the fund still yields 6.5%, but its NAV has slipped to $9. In that one year, income dropped from $650 to $585.

So instead of judging a bond fund by its yield, evaluate its total return—its yield plus or minus any capital appreciation or depreciation.

Seek some variety

You wouldn't choose a fund that buys only health-care stocks as your first equity fund, so why should your first (and perhaps only) bond fund be a narrowly focused Ginnie Mae fund? Yet many investors own bond funds that buy only government bonds, or Treasuries, or mortgages.

For your first—and maybe only—bond fund, consider intermediate-term, broad-based, high-quality bond funds that hold both government and corporate bonds. Those investors in high tax brackets might consider municipal-bond funds, whose income is exempt from income taxes.