How to Evaluate Bond Funds in 2022

Dec 10, 2023 By Triston Martin

Regarding bond funds, it may be difficult to determine what information is most relevant, regardless of whether you are reviewing a research service such as Morningstar, a mutual fund company's website, or a prospectus. As an example, we'll compare the PIMCO Total Return Fund (PTTRX) with the Vanguard Total Bond Stock Index Fund (VTBIX) using these criteria (VBTLX). For active management, the first is extreme; for passive management, the second is the extreme. These products are measured by the Barclays Capital Aggregate (Agg) Bond Index, which is the industry standard. This guide tells you how to evaluate bond funds.


Understanding the Risks of a Bond Fund


Bond fund risk analysis should be a top focus in your research. Investing in bonds entails a wide range of risks. Here are some of the risks listed in the PTTRX prospectus: interest rate, foreign investment (or nation) risk, market, credit, liquidity, foreign currency risk, leverage, and risk management risk, for instance. It's important to note that most domestic investment-grade bond funds remain adequately diversified against these risks, despite interest rate risk being the most notable exception to this rule.


Interest Rate Risks


The value of bonds reduces as interest rates rise, which impacts bond fund returns. To comprehend interest rate risk, you need to know how long it will take for a rate to rise or fall. Simply put, the longer a bond fund's duration, the greater its sensitivity to fluctuations in interest rates. The more sensitive the fund is, the longer the term. For example, if the fund's duration is 4.0, a 1% increase in interest rates would result in a 4% loss in the fund's value. Duration is a suitable starting point for comparing a fund's interest rate risk to another's.


In place of duration, the WAM (weighted average maturity), or "average effective maturity," is a more straightforward statistic. The weighted average maturity (WAM) of the bonds in a portfolio is stated as several years. As interest rates rise, the portfolio will become more vulnerable. In contrast to WAM, which provides just an estimate of interest sensitivity, duration provides an exact assessment of interest sensitivity.


Investment Objectives



All bond funds aim to generate income or preserve capital, for example. Each fund's approach to achieving its objectives distinguishes it from the others. For example, some funds will exclusively invest in bonds issued by the United States federal government or its agencies. In contrast, others would also invest in bonds issued by private companies and municipalities. Some investors may mix and match any or all of these bonds. Ensure the fund's objectives and methodology align with your financial objectives.


Average Maturity


The dollar-weighted average maturity of a bond fund is the average of all the fund's current maturity bonds. A fund's sensitivity to interest rate swings increases as the average maturity lengthens. There are several funds out there that specialize in bonds with a specified maturity range: Bonds with a maturity of one to three years are normally the focus of "short-term" funds; those with a maturity of three to ten years are the focus of "intermediate-term" funds, and "long-term" funds invest in bonds with a maturity of more than ten years.


Duration


When interest rates rise and fall, the bond's price will vary, which is what is meant by the term "duration". A fund with an average term of five years will potentially lose five percent of its value if interest rates increase by one percentage point. However, the share price of a bond fund may also be affected by other circumstances, and the actual performance of the fund may vary.


Foreign Exchange Risk



Foreign currency exposure may also contribute to bond fund volatility. This is true when a fund buys bonds that aren't made in the country's currency. A foreign currency bond's currency returns may dwarf its fixed-income return since currencies are far more volatile than bonds.


For example, the PTTRX permits up to 30% of its holdings to be denominated in a different currency. The fund hedges 75% of its foreign currency exposure to decrease risk. It is not the standard for bond funds that are benchmarked upon the Bond Index of Barclays Capital Aggregate to have exposure to foreign currencies; rather, this kind of exposure is the exception.


Conclusion


It's not necessary to be a financial expert to evaluate bond funds. To get a sense of the fund's future volatility and return, you must concentrate on a few risk and reward indicators. You know precisely what you'll receive if you hang on to a bond until it matures (barring default). YTM and WAM may be used to approximate bond fund returns, but the lack of a set maturity date makes them trickier.

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