Bonds Primer: Choosing a Bond Fund, Part 2

Understand the Morningstar Rating

Before buying a bond fund, check its Morningstar rating, available on Morningstar's Web site.

We don't recommend this measure for stock funds. But with bond funds, the star rating -- an objective measure -- can help eliminate funds that might be putting up the fabulous numbers by taking on more risk than average.

The star rating (explained in more detail in a Morningstar article) evaluates funds based on their success in beating the return on the risk-free three-month Treasury bill (compared with other funds in the same broad category), adjusting that return measure with a risk measure that takes into account the fund's history of underperforming the 90-day T-bill.

Based on those evaluations, funds are awarded one to five stars.

The star rating system gets criticized for failing to predict whether a fund will do well or poorly in the future and for failing to recognize changes in management.

But as Morningstar will tell you, the star rating is not that kind of indicator. It's not anything more than an objective measure of a fund's risk-adjusted past performance.

Bond funds have a better record than stock funds of hanging onto their four- or five-star Morningstar ratings. In response to critics, Morningstar looked at whether funds that had four- or five-star ratings in March 1987 still had these ratings 10 years later. Among taxable bond funds, 60% did. Among municipal funds, 70% did. That compares with a 45% retention rate for diversified domestic stock funds.

Here's an example of how you might use the star ratings. Suppose you're in the market for a no-load government bond fund that requires a relatively small initial investment. If you check out the five-year rankings on our scoreboard, you'd find two funds fitting your criteria: (RSGVX)Rushmore U.S. Government Bond and (STVSX)Strong Government Securities.

Both have 80-basis-point expense ratios, and that's the category median. Now check the star ratings: the Strong fund is rated five, while the Rushmore fund is rated two.

A peek at the portfolios' holdings doesn't explain why the Rushmore fund is relatively risky. It was entirely invested in triple-A-rated government bonds as of June 30, while Strong was only 91.8% in the highest-quality bonds. (The portfolio information is available in our Lipper fund profiles, though at times it's slightly out of date.)

But by looking at Morningstar's Risk & Return profiles of each fund, you can see that these are very different funds. The difference is interest-rate risk. Rushmore is an aggressive fund. When the market does well, it outperforms in a big way. Hence its 32.01% total return, 13.5 percentage points better than the Lehman Brothers Aggregate Bond Index, in 1995. But when the market tanks, as in 1994, this fund lags. It lost 9.94% that year compared with negative 2.92% for the index.

Strong is a more middle-of-the-road fund. Over the last seven years, its best return over the Lehman index was 3.03% in 1993, and its worst underperformance was by a scant 0.63% in 1997.

Rushmore U.S. Government Bond Strong Government Bond Morningstar rating 1 4 1994 total return -9.9% -3.4% +/- Lehman Brothers Aggregate Bond Index -7.0% -0.5% 1995 total return 32.0% 19.9% +/- Lehman Brothers Aggregate Bond Index 13.5% 1.4%

Which fund is right for you? That's up to you. Over the last five years, you would have done slightly better in Rushmore than in Strong -- if you were able to stand the pain of 1994.

Inquiring About the Manager

We relegate the fund manager to the end of the discussion because so many bond funds have limits on credit quality or maturity (essentially interest-rate risk) or both. Those restrictions limit the amount of value a manager can add.

Also, throughout the bond-fund universe, performance correlates so strongly with low expenses that generally it's more important to pick a low-expense fund than it is to pick a talented manager.

Bond fund managers can make a difference. Basically, the more risk a fund can take -- either credit or interest rate -- the more important the manager. (Please see our earlier discussion of credit- and interest-rate risk.)

In a short-term, investment-grade fund, there isn't much a manager can do to distinguish the fund from the pack -- hence the fairly narrow distribution of returns for these funds.

But with a high-yield fund, the manager's judgment can make or break performance. In these categories, it could make sense to buy a fund with a tested manager even if the expenses are a bit higher or if it's a load fund.

The same goes for long-term investment-grade funds, which can take a lot of interest-rate risk, though a note of caution is warranted here. Before expenses, outperformance in long-term bond funds is a function of correctly predicting the direction of interest rates, something "very few" people are able to do consistently, Steve Lipper says. So before you gun for outperformance, consider that long-term, low-expense index fund.

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