Bond funds are similar to mutual funds a bit because they are both collective investment strategies with diversification in their holdings. While mutual funds included stocks, bonds, and other securities, bond funds are solely composed of bond and debt security components.
With the variety of bond funds there may be further subdivisions in classification. According to the Securities and Exchange Commission, “bond fund(s) may concentrate its investments in a particular type of bond or debt security–such as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bonds–or a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility, etc.”
Bond funds are very similar to mutual funds in the way they behave. Bond funds have investment managers who research all their components and create the bond package, they are diversified with and have assortment of bonds in their holdings, bond funds can be bought or sold at will and automatic reinvestment of profits can be scheduled.
Typically bond funds pay dividends higher than CDs and money market rates. The dividends are generated from both interest payments on the fund’s underlying securities and periodic realized capital appreciation. Typically bond funds pay off more frequently than individual bonds, as there are an assortment of investments and corresponding pay out dates.
Despite the safety of having “bond” in their name, bond funds are very different from typical bond investments. Bond funds are higher risk and not a fixed-income investment. Individuals investing in bond funds are not guaranteed their initial investment back – plus interest, and those are the two key ingredients that make a bond.
It is important for consumers to consider the risk of investing in bond funds. Bond funds can default, interest rates or earnings can lower and there are prepayment risks as well. Make sure to read the bond funds prospectus to fully understand the investment before moving your money.