Bonds are publicly traded long-term debt securities. In the U.S., they are issued in denominations of $1,000 by a variety of organizations. Issuers include the U.S. Treasury, various agencies of the U.S. government, state and local governments and corporations.

Compared to other investment vehicles, bonds are known for their interest income and their much lower level of price volatility, especially compared to stocks. As the time to retirement approaches, investors often adjust their asset allocation strategy to move portfolio dollars from equities to bonds in an effort to preserve their wealth.

AAII’s Intermediate Bond Fund Representation

Bonds are present in all three of AAII’s Asset Allocation models, accounting for 10% of the aggressive portfolio, 40% of the moderate portfolio and 60% of the conservative portfolio.

Individual investors can purchase individual bonds. However, owning bonds through an intermediary, such as a mutual fund or exchange-traded fund (ETF), can be much easier. The decision depends on your desire and ability to research bonds, create, track and manage a diversified portfolio of bonds, as well as your risk tolerance and the amount you have to invest.

Bond funds invest in a variety of individual bonds and typically aim to provide investors with regular income. When compared with stock funds, bond funds tend to be less volatile. These characteristics—income and the potential for less volatility—add diversification to a portfolio and may temper overall risk.

Once you’ve decided to opt for bond funds instead of individual bonds, you then need to choose the appropriate fund categories based on issuer type, maturity date and credit quality.

Some bond funds seek to mimic the broad market, investing in short- and long-term bonds from a variety of issuers, such as the U.S. government, government agencies, state and local entities and corporations. Other bond funds focus on a narrower mix of bonds, such as a short-term Treasury fund or a corporate high-yield bond fund.

Across AAII’s Asset Allocation models, intermediate bonds are used for the majority of the bond allocations. Intermediate-term bonds are less sensitive to interest rate changes than long-term bonds and typically provide a greater yield than short-term bonds.

Intermediate bonds in the allocation models are represented by Vanguard Intermediate-Term Treasury Index (VSIGX) as a mutual fund and by Vanguard Intermediate-Term Treasury (VGIT) as an ETF.

These funds employ an indexing investment approach designed to track the performance of the Bloomberg U.S. Treasury 3-10 Year Index, which includes fixed-income securities issued by the U.S. Treasury (not including inflation-protected bonds, floating-rate securities and certain other security types), with maturities between three and 10 years.

This puts the Vanguard funds in the intermediate government fund category. In this category, funds have at least 90% of their bond holdings in bonds backed by the U.S. government or by government-linked agencies.

This backing minimizes the credit risk of these funds, as the U.S. government is unlikely to default on its debt. These funds have durations typically between 3.5 and 6.0 years. The category’s performance and volatility tend to fall between that of the short government and long government bond categories.

The majority of available bonds are taxable at the federal level. In addition to intermediate government bonds, there are two more taxable intermediate bond fund categories: intermediate core and intermediate core-plus.

Intermediate-term core bond funds invest primarily in investment-grade U.S. fixed-income issues—including government, corporate and securitized debt—and hold less than 5% in below-investment-grade exposures. Core-plus funds generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging-markets debt and non-U.S. currency exposures.

Table 1 shows the top 15 intermediate bond funds for each category ranked by five-year return. Table 2 shows the top intermediate bond ETFs for each category also ranked by five-year return.
 

Table 1. Top Intermediate Bond Mutual Funds by Category (Ranked by 5-Year Return)
Download the Excel spreadsheet of this table.

You’ll notice there are fewer ETFs than mutual funds. We left seven intermediate-term bonds off of the table because they were too new to even have a three-year annualized return. First Trust TCW Opportunistic Fixed Income (FIXD) and iShares ESG Aware U.S. Aggregate Bond (EAGG) have been in existence for less than five years, but we included them in the list because of their size.

Table 2. Top Intermediate Bonds ETFs by Category (Ranked by 5-Year Return)
Download the Excel spreadsheet of this table.

Selecting a Bond Fund

All bond funds have similar objectives, such as generating income and preserving capital. However, funds follow different strategies. The basics of evaluating funds apply, including better-than-category-average returns and lower-than-category-average expense ratios. Seek out mutual funds and ETFs grades of A or B for both.

Pay attention to the index tracked and the risk index scores. Higher risk scores imply the fund is taking on more credit risk, holding bonds with greater interest rate sensitivity or both. And both are considerations when selecting a bond fund.

In general, if you have time to ride out the bond market’s ups and downs and are willing to do so, you may reap greater rewards with an intermediate- or longer-term bond fund or one with exposure to higher-yielding, lower-quality bonds.

In terms of favoring growth of capital, a more aggressive bond fund may offer a higher total return, though it comes with greater risk. A long-term bond fund or multi-sector bond fund that has a high yield component may be a consideration.

If you’re investing for shorter time frames or desire less volatility, a more conservative bond fund, such as an investment-grade short-term bond fund, can provide more principal protection. Intermediate bond funds fall in the middle of these two.

It is important to additionally evaluate bond funds by their average maturity, duration and credit quality. This can be done by going to the fund family’s website.

A bond fund may seek to maintain a dollar-weighted average maturity, which is the average of all the current maturities of the bonds held in the fund. The longer the average maturity, the more sensitive the fund tends to be to changes in interest rates.

Unlike common stock, all debt securities, such as bonds, have limited lives and mature on a given date. A traditional bond fund doesn’t have a maturity date itself; rather it is designed to continue on for perpetuity.

Maturity is also used to distinguish a note from a bond. That is, a debt security that’s originally issued with a maturity of two to 10 years is known as a note, whereas a bond technically has an initial term to maturity of more than 10 years.

Duration measures how sensitive a bond’s and bond fund’s price is to interest rates. If rates rise 1%, a rule of thumb holds that a fund with a five-year average duration will lose 5% of its value. Other factors, however, also can influence a bond fund’s share price, and the fund’s actual performance may differ. The key point with duration is that interest rates and bond prices move in opposite directions and the longer the maturity, the greater the price move.

Interest rate risk is the number one source of risk to fixed-income investors holding bonds and bond funds. The interest rate (aka coupon rate) is fixed at issuance for a traditional bond. Because the coupon rate is fixed, it can fluctuate between being above or below prevailing interest rates. This fact creates a risk when investing in bonds and bond funds: The behavior of interest rates, in general, affects all bonds and cuts across all sectors of the market—even the U.S. Treasury market.

Credit risk is the likelihood that the issuer of the bond will default on interest and/or principal payments. Credit risk has to do with the quality and financial integrity of the issuer. The stronger the issuer, the less credit risk there is to worry about. Credit risk is extremely low for some securities (U.S. Treasuries, for example), while for others (like corporate and municipal bonds) it’s a very important consideration.

Ratings are provided by companies such as S&P, Moody’s and Fitch. In the letter scale, the highest credit rating is AAA/Aaa, and bonds in default are assigned C and D ratings.

You can see how these ratings impact the risk index by looking two intermediate core-plus bond funds in Table 1. Brown Advisory Total Return Investor (BIATX) has a total risk index of 0.41. Dodge & Cox Income (DODIX) has a lower total risk index of 0.27. By visiting their respective websites, we can see that the Brown Advisory Total Return fund has a much smaller allocation to government bonds than the Dodge & Cox Income fund (13.7% versus 60.2%).

Treasury obligations are the highest quality bonds because they are all backed by the full faith and credit of the U.S. government. High-yield (aka “junk”) bonds are those with sub-investment grade ratings. The term high yield refers to the comparatively higher yields relative to investment-grade bonds—a reflection of the greater risk.

The amount of interest due from a bond is a function of the coupon, which defines the annual interest income that will be paid to the bondholder. For instance, a $1,000 bond with an 8% coupon pays $80 in annual interest (split evenly into semiannual payments). A bond’s coupon may differ from the prevailing market rate of interest at any given time.

The principal amount of a bond, also known as par value, specifies the amount of capital that must be repaid at maturity. In the U.S., par value is set at $1,000 per bond. Once issued, bonds regularly trade at a premium or discount to their par values. This occurs whenever an issue’s coupon differs from the prevailing market rate of interest and/or there has been a perceived change in credit quality.

Such behavior explains why a 7% issue will carry a market price of only $825 in a 9% market. The drop in price from its par value of $1,000 is necessary to compensate investors for the lower level of interest rates they are receiving. Buyers are compensated by paying less than the par value to acquire the bond.

Be mindful of zero-coupon bonds and funds that specifically target them, such as the top intermediate government bond by five-year return, American Century Zero Coupon 2025 (BTTRX). These bonds do not pay any interest. As such, zero-coupon bonds are sold at a deep discount from their par value, and then increase in value over time at a compound rate of return so that at maturity, they are worth their par value. These bonds are subject to tremendous price volatility when interest rates move.

Table 3 shows averages for each bond fund category on elements such as historical returns, risk, yield and duration. We include this data to provide you with comparative information to assess intermediate-term bonds against.
 

Table 3. Taxable Bond Fund Categories
Download the Excel spreadsheet of this table. 

Conclusion

Bonds can be used conservatively by those who primarily seek high current income, and, in some cases, can be used aggressively by those who go after capital gains in times of volatile interest rates.

Bond funds provide access to this investment security without the hassle of managing individual issues. When included in a well-balanced portfolio, bond funds can help balance the risks associated with stock funds.

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