What Is a Bond Fund?
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John Csiszar
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Emily Gadd
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Bond funds are a collection of debt securities that investors can purchase through a fund company. They are a very diverse asset because the typical bond mutual fund will own hundreds if not thousands of securities. They can be a good choice for investors who don’t have either the skill or the desire to research and invest in individual bonds.
However, this isn’t to say that bond funds don’t have their own risks and drawbacks. Here’s a look at the basic information you’ll need to know.
How 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 will primarily invest in corporate bonds with maturities that don’t exceed 10 years. Each investor owns a proportional amount of the fund – and any income it distributes – based on the amount of their investment.
Income Structure
By law, mutual funds are required to pass through at least 90% of their income to shareholders, and in actuality, most pass nearly 100%. All information regarding the operation of a fund is contained in a prospectus that must be distributed to shareholders by law. The prospectus is where you can find information on returns, investment strategy, risks and other important considerations.
Active vs. Passive Management
In a broad sense, there are two types of mutual funds: actively managed and passively managed. As the name suggests, with an actively managed fund, professional money managers buy and sell securities that they deem to be in the best interest of shareholders. Passively managed funds, on the other hand, simply mimic an index and have low turnover.
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 | Treasury Department | 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 |
Government Bond Funds
The U.S. government has many ways to fund its operations and pay off maturing securities, specifically Treasury bills, notes and bonds. As these are generally considered among the safest investments in the world, backed by the full faith and credit of the U.S. government, they are attractive to conservative, risk-averse investors.
It’s important to note, however, that while the individual bonds in a government fund may not be subject to any real credit risk, all bond funds suffer from risks, particularly interest-rate risk. As bond funds have no maturity, there is no guarantee that you will receive the same amount of money that you put into a government bond fund.
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.
As even the strongest corporation isn’t as financially capable as the U.S. government, corporate bonds have to pay a higher yield premium to be attractive to investors, who are taking on higher risk. But that risk can be minimized with the skill of a professional manager, which is why corporate bond funds are popular with investors who want higher yields without taking on undue risk.
Municipal Bond Funds
Some mutual funds only buy municipal bonds, often simply called “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.
Benefits of Investing in 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 or a handful
- 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
Risks of Investing in Bond Funds
Bond funds aren’t the right solution for every individual investor. Despite their diversification and professional management, bond funds also have risks, including:
- Interest rate risk: When interest rates rise, bond prices fall; as 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; a fund’s expense ratio tells you how much money your fund is taking out of your account every year to pay for management fees and other fund expenses.
Bond Funds vs. Individual Bonds
A bond is one contract between a borrower and a lender. The issuer of a bond, whether the government, a corporation or a municipality, borrows money from investors in exchange for the promise of regular interest payments and the return of principal at maturity.
A bond fund, on the other hand, is a collection of bonds selected by professional money managers. Investors can choose to invest in this portfolio by purchasing shares in the fund. As there are many types of individual bonds, there is also a wide variety of bond funds, each with its own risk/reward characteristics.
| 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 bonds | Lower |
The main advantage of bond funds over individual bonds is that you have a more diversified investment. You also rely on the knowledge of professional investors to make buy and sell decisions on your behalf.
One of the key drawbacks of a bond fund is that it doesn’t have a maturity date. With an individual bond, you know the exact date when your principal will be returned to you, assuming the bond doesn’t default. But funds never mature, so you may never receive your full principal back.
Are Bond Funds Right for You?
Bond funds can be a good choice if you want a complete bond portfolio in a single investment, or if you don’t have the time or knowledge to pick individual bonds on your own. They can also be a wise investment if they meet your income needs.
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.
