Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bond Fund

What it is:

A bond fund is a mutual fund composed of bonds.

How it works (Example):

Bond funds come in many shapes and sizes. Some bond funds only invest in bonds with certain types of coupons, certain types of issuers, certain types of trading characteristics (convertibles, for example), certain types of credit ratings, etc.

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)

How Bond Funds Work
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 usually 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. For example, consider what happens when an investor receives bond income monthly rather than semiannually when the investor is able to reinvest that income at 8% compounded monthly:

Both investors receive the same amount of cash, but because Investor B does not have to wait as long for her income, she can reinvest that income more frequently and ends up with more money in 10 years than Investor A, who reinvested semiannually. The difference is small in this example ($22.40), but consider how big it would be with more income over a longer period. Note that a bond fund's distribution rate usually changes when interest rates change (typically there is some lag, however).

Third, Treasury bond funds, municipal bond funds and some agency-bond funds usually offer shelter from state and/or federal taxes, much like their underlying counterparts. But because most bond funds make taxable year-end capital gains distributions, even municipal bond fund investors may see a tax bill at the end of the year.

Advantages and Disadvantages 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 often higher transaction costs and lower liquidity associated with trading individual bonds -- it's often easier to sell bond fund shares than to sell a particular bond, especially if that bond has unusual characteristics or a low credit rating.

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, which can be already low if the bond fund invests in Treasuries or other low-risk securities.

One major disadvantage of bond funds is that the rule that lower interest rates mean higher prices doesn't always apply to bond funds. When investors buy more shares of a fund, the fund manager must purchase more bonds with the proceeds. In a declining interest-rate environment, this means that the manager is probably buying bonds with lower coupons than before, when rates were high. The inclusion of these low-rate bonds in the fund lowers overall returns and the monthly income available to investors. This in turn lowers the fund's share price, giving investors incentive to sell their shares and putting more downward pressure on the fund's share price. Thus, bond funds tend to reflect current interest rates rather than hold or increase their value when rates go down.

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, offer lower yields than intermediate-term funds, which invest in bonds maturing in five to 10 years.

The relatively low returns offered by bond funds mean that income investors should also pay special attention to fees. Like other mutual funds, there are load and no-load funds, but in general larger funds should have lower fees because of their economies of scale. But the lower the quality of a fund's assets, the higher its fees tend to be because the underlying assets are less liquid and thus incur higher trading costs. Larger funds may offer lower fees and pay less for large blocks of securities, but investors should not ignore small bond funds. Small funds often take meaningful positions in smaller issues that large funds cannot or will not look at. Also, small funds are often better able to exit certain positions because they have less impact on market prices.

The amount of asset turnover in a bond fund is also important to study. Trading costs money, and Treasury bond funds or funds investing in other extremely high-quality debt instruments should have relatively little trading activity. A fund's turnover should be relatively low when interest rates are stable.

Why it Matters:

Bond funds offer many tailored choices that go way beyond simple time horizon. 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) or for more aggressive income investors who want to trade on interest-rate forecasts. Municipal bond funds can be helpful income investments for investors in especially 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 and tend to be more sensitive to changes in their issuers' financial outlooks than to changes in interest rates (they subsequently can actually offer investors a hedge against interest rate risk).