Investing in debt securities carries less risk than stock-based mutual funds, but you still need to determine if bond funds fit your investment goals before putting your money into them. Keep reading to learn more about bond funds and whether they’re right for you:
- How Does a Bond Fund Work?
- What Is the Difference Between a Bond and a Bond Fund?
- What Are the Benefits and Drawbacks of Investing In Bond Funds?
- Types of Bond Funds
- How To Choose a Bond Fund
Bond funds work in much the same way as stock-based mutual funds in that they both hold baskets of investments and arrive at values similarly. In a bond fund, the net asset value per share will determine the value of a particular bond. This is calculated by taking the total value of the bonds and subtracting the fund’s expenses to determine the net asset value. When you divide the net asset value by the number of shares outstanding, you arrive at the value of the bond fund listed on a per-share basis. Prospective investors should read the bond’s prospectus to find information on returns and other important features.
Put simply, a bond is the debt instrument itself, while bond funds specialize in bond investing.
A bond is an individual loan with a promise to return the money upon maturity. A corporation, government, municipality or other entity can issue bonds. Under the agreement, the issuer pays the lender interest at a specified rate over the life of the bond. Once a bond matures, the issuer returns the principal, fulfilling the terms of the agreement.
Bond funds are baskets of bonds offered by investment companies. The bonds can vary in type, risk, duration, volatility and return. Also, since a bond fund invests in several different bonds, it won’t have a maturity date. When an individual bond matures, the fund will likely invest the principal in a new bond, perpetuating the fund.
Like any investment vehicle, bond funds offer both advantages and disadvantages. Understanding how they can benefit your portfolio or reduce your returns can help you determine if bond funds are suitable investments.
As mentioned before, bond funds are a type of mutual fund. Hence, you pay the expense ratio and professional investors find the bonds that will deliver stable returns at a lower risk.
The fact that funds own multiple bonds reduces risks. For example, if a municipal bond fund gets hurt when cities default on debt, as some did during the financial crisis, most bond funds will have sufficient diversification to minimize the impact.
Also, because bond funds don’t mature after a specific period of time, you can buy a bond fund at any time at the prevailing price. If it no longer suits your needs, you can also sell the fund at any time as long as the buyer accepts the current market price.
One potential risk of a bond fund is that your selling price might fall below your original purchase price. In this case, it’s possible to lose money in bond funds even though they carry less risk than other types of mutual funds.
Another drawback of a bond fund is the interest-rate risk. This occurs when a fund invests in low-interest bonds and interest rates then rise. With returns lower than prevailing market rates, the value of bonds typically fall in this situation. Bonds also face prepayment risk, where an issuer pays off a bond early. This can become a factor after interest rates fall and the issuer reissues bonds at a lower interest rate.
Investors can choose from different types of bond funds, which helps you either lessen risk or take on more risk for a higher return. Some funds even allow for tax advantages. Here are a few popular types of bond funds:
Investment-grade bond funds buy bonds issued by entities with high credit ratings. These bonds carry the lowest credit risk. U.S. Treasury bonds and high-grade corporate bonds fall into this category.
Learn More: How To Invest in Bonds
These funds buy bonds that offer higher-than-average interest rates. However, they also come with a lower credit rating, increasing the credit risk. Entities with a troubled credit history sometimes issue high-yield bonds.
Other funds buy only “munis,” which are bonds issued by state, county and municipal governments. In most cases, these are exempt from federal income tax. Some are also exempt from state and local taxes under certain conditions.
As the name implies, these funds invest in multiple sectors of the bond market and typically take on more credit risk. According to Sarah Bush, the North American manager research practice leader at Morningstar, these funds typically invest between one-third and two-thirds of their portfolios in bonds that come in below investment grade.
International funds buy bonds issued by companies or governments outside of the U.S.
These can offer higher returns and allow investors to profit from currency fluctuations. Just keep in mind that currency movements can also cause losses. Political risks and differing market operations can also add to the uncertainty.
Deep Dive: How To Choose the Best Types of Bonds to Buy
Given the variety of choices available, choosing the right bond fund can seem just as daunting as trying to understand the funds themselves. As mentioned earlier, your first move should be to research a fund’s prospectus to find pertinent information about its investments, expense ratios and rates of return. If you feel you need more help, you can also consult an investment professional to determine if a particular bond fund is right for you.
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