Now that the subprime credit imbroglio has jolted the Federal Reserve out of its tightening crusade and into an easing mode, it's getting harder to find a bond fund with a decent dividend yield.
The central bank slashed its key Fed funds rate by another 25 basis points to 4.5% Wednesday. That came on the heels of a 50 basis point cut in September.
The Fed's move resulted in the U.S. dollar losing value, which in turn diminished demand for longer-term domestic fixed-income vehicles. Since yields move in the opposite direction of bond prices, they actually edged higher on most longer-term bonds.
Nonetheless, indicated annual yields on most bonds and bond funds still remain painfully anemic.
And just to complicate matters, there's a risk that bond fund managers will take on too much risk in the search for higher yields. This can put a fund's principal at risk and thereby jeopardize its ability to generate a satisfactory level of future payments to holders.
As a result, investors looking for fixed-income mutual funds with appealing payouts need to be especially selective during times like these.
The big danger for investors is that if a fund's principal erodes, the remaining investment base will no longer be sufficient to support an above-average yield.
TheStreet.com Ratings database is here to lend a hand. We screened our database for bond funds that have been holding their own in the yield column without sacrificing their principal investment balances.
An important note: mutual-fund returns are usually calculated using the assumption that all dividends and capital gains distributions are reinvested; but for fixed-income funds it is frequently useful to take "principal" returns into consideration. This is the appreciation of the principal amounts of the respective portfolios, excluding dividend payments.
It's common sense that if a manager allows his fund's principal investment amount to slide in his quest for a superior dividend return, the fund's ability to maintain its level of payments will be jeopardized.
With this in mind, TheStreet.com Ratings database of open-end bond funds was filtered to identify those with above-average dividend yields
as well as
positive one-year "principal returns."
Just to be sure of avoiding funds that might have exposure to subprime mortgages, we added a third filter, excluding those that list their investment objectives as either "loan participation" or "mortgages."
The list was further refined to limit the list to retail funds with minimum initial investment requirements of no more than $25,000.
The top portion of the accompanying table displays the taxable fixed-income funds with positive one-year principal returns, current indicated dividend yields of at least 5% and marks in the "A" and "B" ranges from TheStreet.com Ratings. These are our two highest grades, and they equate to "buy" recommendations.
The nine tax-exempt funds in the lower portion of the tablet passed the same test but with a lower current indicated dividend yield threshold of 3%. The municipal bonds these funds hold can get away with smaller payouts because they are not subject to tax.
With muni bond funds, some investors prefer principal returns of close to zero, as capital gains on their investments are potentially taxable. Tax avoidance is a primary factor is their choice of tax-exempt bonds in the first place.
All the taxable and tax-exempt funds on the list pay monthly dividends, with the exception of the
Osterweis Strategic Income Fund, which makes quarterly payments. Its top holdings are a bond issued by Amsted Industries with a coupon of 10.25% that matures in October 2011 and one issued by Nova Chemicals with a 7.4% coupon that matures in May 2009.
While few are predicting that the Fed will start raising interest rates again anytime soon, the exploding price of crude oil, coupled with higher import prices resulting from the deteriorating value of the U.S. dollar, could reignite inflationary expectations and send bond prices southward.
In that scenario, bonds relatively close to maturity would suffer less than those with lengthier life spans. Most of the taxable as well as tax-exempt funds on the list are of short- to intermediate-term maturities, thereby providing some degree of immunity to price erosion that might result from interest-rate jitters.
Richard Widows is a financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.