Ask the Expert: Bond funds

August 24, 2010

| MoneyRates.com Senior Financial Analyst, CFA

Q: What do you think of bond funds right now? If they are a buy, which fund?

A: Bond funds are a little scary right now. There has been talk of a bond bubble, with investors who've been burned by stocks, real estate and other riskier investments piling into bonds and driving the price up (which drives interest rates down). Calling it a speculative bubble might be overstating it--with high-quality bonds, at least, you can be assured of realizing value over the long-term, which you can't say about truly speculative assets.

Still, with 10-year Treasury bond yields down to 2.61 percent, there are two very important assumptions you would be making if you bought bonds now:

  • Assumption #1: Interest rates will remain near record lows or move even lower. With interest rates already as far down as the Federal Reserve can push them, a bet on bond yields now is a bet against history.
  • Assumption #2: Inflation won't flare up. A return to even historical average rates of inflation would put current bond yields below the inflation rate--meaning investors would be losing purchasing power.

Certainly, bonds--just like money market accounts and CDs--almost always have a place within a well-diversified portfolio. However, this doesn't seem like a great time to make an unusually big investment in bonds.

As for choosing individual bond funds, you should focus on three things:

  1. Quality. Lower-quality bonds may expose you to some of the same economic risks as the stock market.
  2. Fees. With bond yields so low, pay special attention to fees that can quickly overtake gains.
  3. Performance when interest rates are rising. The bond funds that look best over the past couple years are those most geared to falling interest rate trends. Balance this out by looking at performance during a rising rate environment, such as October 2008 through October 2009, or going back farther, the years 2003 through 2005.

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