What Is a Bond Fund? How It Works and Why Investors Use Them
Written by
Rudri Patel
Edited by
Elizabeth Constantineau
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You may be familiar with bonds, but bond funds are a different way to invest in them. A bond fund is a professionally managed pool of bonds — held inside an exchange-traded fund (ETF) or mutual fund — that gives you instant diversification without having to monitor each bond yourself. Unlike individual bonds, bond funds don’t have a set maturity date, but they typically pay monthly distributions from the interest earned.
Quick Take: Bond Fund Basics
- What you get: A diversified mix of bonds that reflect several sectors. Bond funds are managed by a professional and can be automatically reinvested.
- When do you get paid? You’ll receive interest payouts monthly or quarterly, depending on the fund.
- Key benefits: Instant diversification, hands-off approach and lower risk than stocks.
How Do Bond Funds Work?
Bond funds are pools of money collected from investors. Professional money managers invest this collective pool in a basket of bonds that are in line with the fund’s stated objectives.
For example, an intermediate-term corporate bond fund mainly invests in corporate bonds with maturities under 10 years. Each investor owns a proportional share of the fund — and its income — based on how much they invest.
How Bond Funds Are Managed: Active vs. Passive
Bond funds fall into two management styles:
- Actively managed funds: Professional money managers buy and sell securities that they believe will outperform the market.
- Passively managed funds: These funds track a specific index and have low turnover.
Here are some key differences to keep in mind:
| Feature | Active Bond Fund | Passive Bond Fund |
|---|---|---|
| Goal | Surpass a benchmark | Keep up with a benchmark |
| Fees | Higher | Lower |
| Turnover | Typically higher | Lower |
| Best for | Investors who want a manager making strategic decisions | Investors who want simple, low-cost market exposure |
How To Measure Performance
To understand how well your bond fund is doing, look at these metrics:
- Return: What is the distribution?
- SEC yield: What is the current income estimate?
- Duration: How is the bond responding to interest rate sensitivity?
- Spread exposure: What is the credit quality of the bonds?
- Expense ratio: How low is the expense ratio?
Types of Bond Funds
Investors can choose from different types of bond funds to diversify their portfolios and gain access to multiple types of bonds. This can help reduce a portfolio’s risk/reward ratio, and in some cases may even provide some tax advantages.
Here are a few popular types of bond funds.
| Bond Category | Issuer | Income | Taxation | Default Risk |
|---|---|---|---|---|
| Government | U.S. Treasury | Low | Exempt from state taxes | Near-zero |
| Municipal | City, state or local government | Low, but can be high on an after-tax basis | Tax-free federally, and often state and locally in the place of issue | Low |
| Corporate | Companies | Higher | Fully taxable | Variable |
| High-yield junk bonds | Corporations with subpar investment grades | Higher | Fully taxable | High |
| International and emerging market funds | Foreign governments and companies | Yields vary | Fully taxable | Medium to high |
| Mortgage- backed securities funds | Agency pools and non-agency issuers | Typically above Treasuries | Fully taxable | Low to medium for agency, high for non-agency |
| Multi-asset class funds | Governments, agencies, corporations and public companies | Bond interest plus equity dividends | Fully taxable | Default risk depends on credit quality |
Government Bond Funds
The U.S. government issues Treasury bills, notes and bonds to fund operations and repay debt. Backed by the government’s full faith and credit, these securities are among the safest options for risk-averse investors.
Best for: Investors who want stability and capital preservation.
Corporate Bond Funds
Corporate bond funds own bonds issued by individual companies, instead of by the government. Although these bonds are “guaranteed,” that promise is only worth the financial strength of the company issuing them.
Best for: Those looking to diversify assets with moderate risk.
Municipal Bond Funds
Some mutual funds buy only municipal bonds, or “munis.” These bonds are issued by state, county and municipal governments. In most cases, they are exempt from federal income tax. Some are also exempt from state and local taxes under certain conditions.
Best for: Investors in higher tax brackets.
High-Yield Junk Bond Funds
High-yield junk bond funds are sub-investment-grade corporate bonds that come with a risk. These bonds have the possibility for higher returns but are often volatile.
Best for: Those who have money they are willing to risk.
International and Emerging Market Funds
These bond funds are focused on diversifying your portfolio to gain exposure to global markets. You may yield higher returns, but will have to be comfortable when governments face political risk.
Best for: Investors who want exposure to international markets.
Mortgage-Backed Securities Funds
These funds pool together bonds backed by agency and non-agency mortgages. Investors typically receive monthly income.
Best for: Those who want more yield than Treasuries and are comfortable with some risk.
Multi-Asset Class Funds
Multi-asset class funds are a mix of stocks and bonds in one fund. Typically, this bond fund is automatically rebalanced.
Best for: Investors seeking a one-stop option for both bonds and stocks.
Benefits of Bond Funds
Bond funds are popular because they offer a host of benefits. Here are the primary ones:
- Diversification: Most bond funds own hundreds or thousands of bonds, diversifying the risk of owning just one.
- Professional management: Investors don’t need to be experts to buy bonds because they are hiring industry experts to do the work for them.
- Regular income: Most bond funds pay income monthly.
- Liquidity: Bond funds are easy to buy and sell at the current net asset value.
When Bond Funds Might Be a Good Fit
- A bond fund can help diversify your portfolio.
- You prefer a hands-off approach instead of managing individual bonds.
- You’re looking for steady, predictable income.
- You want a lower-risk option than stocks.
Risks of Bond Funds
Despite their diversification and professional management, bond funds also have risks, including:
- Interest rate risk: When interest rates rise, bond prices fall. Since bond funds have no maturity, there is no guarantee of the return of your principal.
- Credit risk: This refers to the risk that an issuer will go bankrupt and no longer be able to fund its obligations.
- Liquidity risk: During market turmoil, bond prices may become erratic, making it harder for managers to get good prices on behalf of customers.
- Management fees: It can be expensive to run a bond fund, and investors have to foot the bill. Check the fund’s expense ratio to see how much money your fund is taking out of your account to pay for these fees.
Bond Funds vs. Individual Bonds
Weighing the choice of bond funds or individual bonds? Here’s a rundown of the differences.
| Investment Type | Income | Risk of Principal | Taxation | Cost |
|---|---|---|---|---|
| Bond fund | Usually higher | Higher | Taxable, except for municipal funds | Higher |
| Individual bond | Usually lower | Lower | Taxable, except for municipal funds | Lower |
Bond Funds
- A collection of bonds selected and managed by professional money managers.
- There is no set maturity date — the fund continues indefinitely.
- Distributions usually occur monthly or quarterly.
- Provides broad access to many types of bonds.
- Diversification is instant because the fund spans many sectors.
Individual Bonds
- A contract between you and the bond issuer.
- You get to pick your bond, and it comes with a set maturity date.
- Exposure is limited to one issuer or sector unless you buy multiple bonds.
- Provides more control, since you select each investment yourself.
How To Invest in Bond Funds
Ready to invest in bond funds? Here’s how:
- Set your goals: Do you want a stable income? Do you want to diversify your investments? Decide what you’re looking for first.
- Pick an account: Choose where you’ll hold the fund — a taxable brokerage account, a 401(k) or an IRA.
- Select a fund category: Determine whether you want a corporate fund, government fund, international fund or another type.
- Match the fund’s duration to your risk tolerance: Short-term bond funds are lower risk, intermediate bonds offer balance and long-term funds are more sensitive to interest rates.
- Decide between an ETF and a mutual fund: Mutual funds trade once a day, while bond ETFs trade all day.
- Compare the key indicators: Look at expense ratios, historical performance, SEC yields and other factors.
- Determine the after-tax return: For taxable bond funds, calculate how much you’ll receive after taxes.
- Place your order: Once you decide on the fund, place your order with the brokerage.
- Set distribution preferences and rebalance: Decide whether you want dividends reinvested or taken as cash, and periodically review your portfolio to rebalance if needed.
Final Take
Bond funds can be a good choice if you want a complete bond portfolio in a single investment. They are also a smart pick if you don’t have the time or knowledge to pick individual bonds on your own.
However, it’s important to note that bond funds are more expensive than individual bonds, and they don’t have maturity dates. This means they’re the best choice for investors who prioritize income over the guaranteed return of their capital.
As these types of investments can get complicated, it can be a good idea to consult with a fiduciary financial advisor to determine if a particular bond fund is right for you.
Bond Fund FAQs
Still have questions about bond funds? Here are the basics.- How does a bond fund work?
- In a bond fund, investors pool their money together to buy a set of bonds. This bond fund is managed by a professional.
- Is a bond fund a good investment?
- A bond fund is good for steady income and diversification.
- What are the disadvantages of a bond fund?
- You don't necessarily control the type of bonds that are held. When interest rates rise, fund values can dip.
- How do you make money from a bond fund?
- You can get the interest income from the bonds inside the fund. Also, you can get capital gains if you sell the fund for a profit.
John Csiszar contributed to the reporting for this article.
