The Categorization of Bond Funds

Bond funds are classified by the types of bonds they hold, the average duration and quality of those bonds, and the issuers of the bonds held by the funds. You will find there are bond mutual funds that specialize in everything from long-term U.S. Treasury bonds to private sector emerging markets debt. Everything you need for the bond component of your portfolio is available as a bond mutual fund.

The average duration or maturity is based on the remaining time to maturity rather than the original term of the bonds. So a ten year Treasury note issued three years ago has seven years left until it matures and is therefore currently equivalent to a seven year note, which would be considered intermediate in a standard style box.

Morningstar defines short, intermediate and long durations as 1 year to 3.5 years, greater than 3.5 years but less than 6 years, and 6 years or greater, respectively. Anything less than one year falls in the category of cash equivalents such as T-bills and money market funds. Note that Morningstar does it right, they use duration rather than average maturity to define short-, intermediate- and long-term.

Quality is the next criteria to consider. This may be the most important factor to you, but you need to find the bond funds with the appropriate duration before you can apply this criteria.

U.S. Treasury debt is the highest quality in the world and U.S. Agency debt (GNMA, FNMA and FHLMC) that is guaranteed by the federal government is nearly as good, in most cases on a par with AAA corporate bonds. That was easy, the rest gets a bit more complicated.

You may think that municipal bonds are just about as safe as U.S. Treasury debt, but local governments have been known to default on their debt, like when Orange County, CA, declared bankruptcy in 1994. And it seems there's usually at least one state that's in dire straights and on the verge of defaulting on its debt at any given time. Most of the muni defaults have been very large.

"How can this be?", you say. Well, munis fall in a gray area between Treasuries and corporate debt with respect to the transparency mandated by the SEC. In short, there is very little public information readily available on municipal bonds and this leads to a lack of oversight. Also, munis can be issued to fund investor-led projects such as sports stadiums, housing projects and hospitals. Investor-led projects often depend on revenue generated by the projects to make interest and principal payments, and the projects are subject to the same types of risk as private sector projects.

There are two types of municipal bonds: 1.) General obligation bonds, which are secured by the full faith and credit, and taxing and legislative authority of the issuer, which makes these relatively safe investments. 2.) Revenue bonds, which are secured by the revenue expected to be generated by the project being funded by a particular issue, such as a toll road or hospital. The obvious inherent risk of revenue bonds is that the projects they fund may fail to generate enough revenue to cover interest payments and the eventual return of your principal.

A well-diversified municipal bond fund will limit your exposure to individual jurisdictions or you can stick with bond mutual funds that only invest in insured municipal bonds.

The bonds of U.S. corporations span the spectrum from nearly as creditworthy as the U.S. government to highly speculative (a.k.a. Junk). "The Handbook of Fixed Income Securities" by Fabozzi & Fabozzi, breaks bonds into three major categories: Investment Grade (high creditworthiness), Distinctly Speculative (low creditworthiness) and Predominantly Speculative (Substantial risk or in default).

In layman's terms, corporate bond quality can be broken into five categories: very high grade (Triple A corporate and U.S. Treasury), high investment grade, low to intermediate investment grade, below investment grade (speculative) and way below investment grade (highly speculative). These five tiers are what I've used in the extended bond style box above.

I added the Very High tier to distinguish those bond mutual funds that only invest in bonds of the very highest quality. The Very Low tier was added for those bond funds that are biased toward the very lowest quality bonds, those with C and D ratings. I thought this was fair in that some high-yield bond funds do not invest below the Bs and many include some low investment grade bonds in their portfolios, thus distinguishing them from those that venture into C and D territory. You'll need to take a look at the distribution of the ratings of a bond fund's holdings to make this distinction.

The next criteria to consider is the general category of the issuers of the bonds held by a bond fund. In the expanded style box, I've broken this criteria down into seven categories: U.S. Corporations, U.S. Treasury, U.S. Government Agency, National Municipal (i.e., diversified), State-Specific Municipal, Developed Markets (non U.S.) and Emerging Markets. Each of these seven categories can be further subdivided, some more than others.

These seven categories of bond mutual funds provide opportunities for diversification in your portfolio and a lot of options to meet your investing objectives. Income is the most obvious objective that can be satisfied, at least in part, by bond funds. And if you're investing money in a taxable portfolio and you're in a high tax bracket, the tax-free income from some municipal bond funds is another possibility. Preservation of capital also is an objective that can be satisfied by investing in bond mutual funds with high quality ratings.

Detailed descriptions of the various types of bond funds can be accessed via text links from the list of Types of Mutual Funds.

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