Domestic Bond Mutual Funds

Domestic bond mutual funds can be subdivided into five main categories: corporate, U.S. Treasury, U.S. government agency, diversified municipal and state-specific. These funds offer individual investors the opportunity to participate in all of the domestic debt markets.

Many domestic bond mutual funds invest in both Treasury and investment grade corporate bonds. These bond funds are usually labeled generically as short-, intermediate- or long-term bond funds. Mixing Treasury and corporate bonds serves three purposes. It gives the fund managers many more options to choose from, it gives them two distinct markets to choose from, which is beneficial in that one may be expected to outperform the other at any given time, mainly because the spread between the two varies with investor confidence, and including treasuries adds insurance against default and raises the overall quality of a fund's portfolio.

In the interest of simplicity, I'm not going to address the individual components of diversified domestic bond mutual funds directly. Just be aware that many bond funds are managed this way and that anything that applies to corporate and Treasury bond funds also applies to the respective components of the diversified funds.

Corporate bond mutual funds span the quality spectrum from AAA to "highly speculative." This gives you a lot to choose from to meet your investing objectives.

If your objective is income and capital preservation, a domestic bond mutual fund that invests exclusively in the very highest rated corporate bonds will provide you with a little more income than a pure Treasury bond fund with nearly the same level of creditworthiness.

You will get much better yields with medium grade corporate bonds, which still span a pretty good swath of the quality spectrum. Most of the companies whose debt lands in this pool are solid or reasonably solid firms. Some may be tumbling downhill for some reason but the fund analysts, traders and managers know how to identify these companies and usually manage to avoid them.

The mediocre creditworthiness of this group can be attributable to a few factors. The companies may be relatively small and/or young and thus not have a well established track records; they may have more debt than similar companies; their balance sheets may be weak compared to industry norms; individual bond issues may be subordinate to other bonds issued by the same companies.

Although individual bond issues in this group may be risky relative to the higher grade corporate bonds, a professionally managed diversified portfolio of these bonds, which is what you get with a mutual fund, delivers relatively high returns with minimal risk. Thus, this can be the sweet spot of the bond market when times are good, but your NAV is apt to sag whenever there is a flight to quality when investor confidence is weak.

Finally, we have the high-yield or junk bond funds. I look at this sector as having two distinct segments: high-yield (low quality) and junk (very low quality).

The true junk is at the bottom of the barrel, which earns it a very low quality rating. These companies are in default or very likely to be in default before their debt matures. Domestic bond mutual funds that invest in these C and D rated bonds are indeed highly speculative, i.e., high risk, thus their extremely high yields.

The high-yield funds can offer very good returns to anyone willing to accept a fair, but not extraordinary, amount of risk. Most of these funds, which I rate as low quality, invest in bonds that are rated above C and often extend into the lower range of the investment grade bonds. They're still riskier than the medium quality bond funds, but a good bond fund should be able to avoid most of the issues that are likely to default or have their credit further downgraded. However, if something terrible happens to the economy, all bets are off. Any weak companies in this group are likely to become history.

Investment grade corporate bonds are somewhat correlated to the general market, making them a bit less attractive than Treasury bonds for diversification of your portfolio. As Treasury bonds are only slightly correlated to the general market, they're a better option at the high end of the quality scale. When comparing medium to high grade corporates to Treasuries, you will have to determine if the higher yield of the corporates is worth their attendant higher correlation.

It becomes a tougher call with high-yield corporate bonds. They offer a much higher yield but they also are moderately correlated to the general market, making them less attractive than investment grade corporate bonds as a diversifier. And, of course, they're much riskier.

Corporate bonds also include convertible bonds, which derive their name from the option to convert these securities to common stock, and there are bond funds that invest mainly in convertibles. These bonds, and the funds that hold them, have a lower yield to compensate for the option to convert but they also offer the potential to reap a significant capital gain upon conversion.

U.S. Treasury bond mutual funds are just what you'd expect them to be, domestic bond mutual funds that invest in U.S. Treasury bonds. These are the most secure of all the domestic bond mutual funds. If preservation of capital is your primary objective, U.S. Treasury debt is your best option.

Treasury debt has its own nomenclature. In general, bills (a.k.a. T-Bills) are issued with maturities of less than one year, notes are issued with maturities of one to 10 years and bonds are issued with maturities greater than 10 years. However, this terminology is not commonly used in the names of funds that specialize in Treasury debt. Thus an intermediate-term treasury bond fund might hold newly issued 10 year notes and bonds whose remaining term to maturity is seven years.

The U.S. Treasury also issues TIPS (Treasury Inflation Protected Securities), which are issued with a base interest rate and the principal is subsequently indexed to inflation, thus the interest payments and the amount of the eventual repayment of the principal vary with inflation. TIPS are currently (July 2010) issued with terms of 5, 10 and 30 years, but this can change from time to time.

Although Treasury debt yields less than the highest quality corporate bonds for any given maturity, the yield is not significantly lower than high quality corporate debt but its degree of correlation is significantly lower than high quality corporate debt, thus making it a better option for your portfolio.

U.S. Government agency bond mutual funds invest in the debt securities of federal agencies. As these securities are usually guaranteed by the federal government, they are almost as secure as Treasury debt.

Although the agencies include GNMA, FNMA and FHLMC, all of which issue mortgage-backed securities, most no load mutual funds currently restrict their investments to GNMA, which is the only one of the three that is still a true government agency, the other two are now government chartered public corporations, but their debt is still guaranteed by the government.

Government agency bonds are somewhat negatively correlated with the general market, thus mutual funds holding these bonds should be excellent diversifiers. Given that the yield on agency debt is slightly higher than Treasury debt and that the returns on government agency bonds are negatively correlated with the general market, I would say that these funds would generally be a good candidate for your portfolio. However, in 2007 and 2008, mortgage-backed securities were definitely out of favor with investors due to the many quality issues that became apparent in mid 2007.

Diversified domestic bond mutual funds hold both U.S. Treasury bonds and corporate bonds. These are many in number and include some of the largest and most well run bond funds.

Treasury bonds are only slightly correlated with the general market and corporate bonds are only slightly more correlated with the general market than Treasury bonds. Therefore, adding one of these funds as all or part of the bond component of your portfolio rather than a pure Treasury fund shouldn't have a significant impact on the overall diversification of your portfolio. And it could actually help you.

As these diversified domestic bond mutual funds offer a wide selection and include some of the best-run bond funds, it's very likely that you'll find one that offers good return relative to risk and has a correlation to the general market that is at least as low as a Treasury bond fund with an equivalent duration.

Municipal bond mutual funds invest in the bonds of states, counties, cities and other local governments and their agencies. Municipal bonds are either general obligation bonds or revenue bonds and they may or may not be insured.

As the payment of interest and principal on revenue bonds must come from revenue generated by the projects they fund, these bond are much riskier than general obligation bonds. In either case, insurance minimizes the your risk, but you can expect the reduced risk to be accompanied by a lower yield.

Municipal bond funds are either state-specific or diversified nationally, with the state-specific funds offering tax-free interest to residents of the state whose bonds they hold. The interest from most municipal bonds is exempt from federal taxes.

Less than half of all municipal bonds are issued without a rating, which automatically earns them high-yield status, whether they deserve it or not. But either type of muni, revenue or general obligation, can become high-yield candidates if the issuers' credit ratings are lowered significantly or, in the case of revenue bonds, the underlying projects are not producing enough revenue to make the interest payments or, in the worst case, the projects appear to be doomed and there will be no revenue for the repayment of principal.

Investment grade municipal bonds are slightly negatively correlated to the S&P 500 and high-yield minis are slightly positively correlated to the S&P 500, thus making both attractive candidates for diversifying your portfolio.

The fact that less than half of municipal bonds are rated presents a good opportunity for funds that understand municipal bonds and are willing to expend the resources on due diligence to unearth some gems that are yielding much more than their true risk would warrant, as many of these unrated bonds are only classified as high-yield because they are unrated. A domestic bond mutual fund that can consistently find these undervalued assets can deliver returns that are disproportionately high for their true level of risk. But, as with high-yield corporate bond funds, anything that causes a flight to quality will cause the NAV of such funds to drop, whether it's warranted or not.

Targeted maturity bond mutual funds invest in high quality debt securities with terms set to mature in a specific year. These funds may invest a portion of their portfolios in securities with shorter terms than the life of the funds and roll them progressively into other short-term securities with the last increment set to mature at the target date.

Targeted maturity bond funds are an alternative to diversified targeted funds, which invest in a blend of stocks and bonds then diminish the proportion invested in stock as the target date approaches.

Domestic bond mutual funds offer a broad selection of income-producing investments that add diversity to your portfolio and, with a few notable exceptions, also offer preservation of capital.

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