What is a Bond Fund?

A bond fund is a mutual fund or exchange traded fund (ETF) composed of bonds.

How Does a Bond Fund Work?

Bond funds come in many shapes and sizes. Some of the major bond-fund categories are:

  • U.S. Treasury bond funds

  • Municipal bond funds

  • Mortgage-backed security funds

  • Corporate bond funds (within this category are several subcategories based on target maturities, credit rating, industry, etc.)

  • International bond funds

  • Mixed (where the fund manager invests in a variety of different bond categories)

It's important to note that bond funds are composed of bonds, but they don't always behave like bonds.

First, bond funds do not mature like individual bonds do. Instead, fund managers buy and sell bonds of differing maturities, which produces constantly changing trading profits, losses, and yields. Although a bond fund's investments do mature, the fund's investors typically don't get their original investments back until they sell their shares (and even then there is no guarantee the fund's share price won't be below the investor's purchase price).

Second, bond funds often make monthly payments to investors, while bonds normally make only semiannual payments. Thus, bond funds provide more frequent income and a better opportunity to leverage the power of compounding when reinvesting.

Advantages of Bond Funds

Most investors agree that it is usually easier and less expensive to invest in bond funds than to choose each and every bond in a portfolio. And aside from the convenience of monthly payments, a bond fund's instant diversification often means lower risk. Bond funds also are a way to avoid the high transaction costs and lower liquidity associated with trading individual bonds -- it's often easier to sell bond fund shares than to sell shares of an individual bond.

Bond funds also offer the services of a professional who watches and acts on the interest rate environment on behalf of the investor, handles the trading decisions and determines the asset allocation. Fees for these services, however, can eat into returns.

How to Choose and Purchase a Bond Fund

Purchasing shares of a bond fund is as easy as purchasing shares of any other mutual fund -- simply call your broker or purchase the shares using an online trading account. Evaluating and choosing a bond fund that best fits the investor's portfolio, however, is trickier. The most important document to study is the prospectus, which provides information about the bond's investment methods, goals and strategies as well as background on the fund manager and a list of specific holdings.

One way to compare fund returns is to look at their 30-day annualized yields. This number is calculated according to a very specific, complex formula provided by the SEC and is intended to prevent manipulation of yield calculations. Funds must also present one-year, five-year and 10-year annualized returns as well.

Income investors also should consider their investment horizon. Short-term funds, which typically invest in bonds maturing in one to five years, typically offer lower yields than intermediate-term funds, which invest in bonds maturing in five to 10 years.

The amount of asset turnover in a bond fund is also important to study. Because frequent trading costs money, you might want to consider investing in bond funds with relatively low turnover ratios.

Why Do Bond Funds Matter?

Bond funds offer many tailored choices that go way beyond simple time horizons. For example, target maturity funds are great for investors who need a certain amount of money for a specific purpose at a specific point in the future (such as college tuition). Municipal bond funds can be helpful income investments for investors who are in high tax brackets. International bond funds offer more return and risk potential from their investments in bonds issued by foreign governments or foreign companies in a variety of markets, industries, and currencies.

Even higher on the risk spectrum are high-yield bond funds, which invest in corporate bonds rated below BBB. These funds tend to be more volatile, as well as more sensitive to changes in their issuers' financial outlooks.