When building a diversified fixed income portfolio, bond funds can be an effective approach. Not only can they provide benefits like monthly income and daily liquidity, they also provide diversification potential and professional management, meaning you don’t have to worry about managing your fixed income investments on a day-to-day basis. Building a portfolio of fixed income funds starts with identifying your investment goals, then understanding how different types of bond funds align with those goals.
When it comes to creating a portfolio that will generate income, there are 3 types of building blocks to consider.
- Stable and highly liquid investments, such as money market funds, which seek to preserve your initial investment while providing some yield
- Bond funds that invest primarily in investment-grade securities, offering higher yields than money market funds and less volatility than bond funds investing in high-yield, lower quality securities; typically invest in bonds issued by the U.S. government, government agencies, corporations and/or municipalities
- Bond funds that invest in high-yield, lower quality securities, which deliver potentially higher returns in exchange for greater risk
Some investors may find all they need in certain broad market funds that meet much or all of these criteria. Others may opt to invest in 2 or 3 funds that together achieve the diversification they seek across different sectors, maturities, credit quality, and yield. What follows is an overview of the various types of bond funds you can choose from.
"Investment-grade bond funds" is a broad term that encompasses funds that invest in high-quality bonds that have been rated "investment grade" by the bond ratings agencies. (Read more about Bond ratings.) These high-quality bonds include those issued by the U.S. Treasury and other government agencies, as well as some corporations. Most mortgage-backed bonds are also rated investment grade.
Types of funds that fall into this broad category include:
- Government bond funds. Government bond funds invest primarily in bonds issued or guaranteed by the U.S. government, such as Treasury bonds and bills, as well as mortgage- and other asset-backed securities backed by the government. These funds may also invest in bonds issued by government-sponsored enterprises, such as Fannie Mae and Freddie Mac, that are not explicitly backed by the U.S. government. Because of the high credit quality of their underlying investments, government bond funds will not offer the highest yields, but are a good way to offset some of the credit risk you may have in other parts of your portfolio.
- Inflation-protected funds. These funds primarily invest in Treasury Inflation Protected Securities (TIPS). TIPS are bonds whose face value adjusts to keep pace with the Consumer Price Index (CPI), making them a good hedge against inflation.
- Mortgage-backed bond funds. Mortgage-backed bond funds invest in securities backed by pools of mortgages. These securities can be issued by government sponsored enterprises—such as Fannie Mae—or by a bank or other financial institution. Since mortgage-backed bonds are normally considered to have more risk than U.S. Treasury securities, they typically offer higher interest rates. For that reason, mortgage-backed funds could be an attractive investment for those willing to assume a bit more risk in exchange for potentially higher current income.
- Corporate bond funds. These funds invest in corporate bonds. Corporations issue bonds to expand, modernize, cover expenses and finance other activities. The yield and risk are generally higher than government and most municipal bond funds. Rating agencies help you assess the credit risk by rating the bonds according to each company's financial profile. Income from corporate bonds is fully taxable.
High-yield bond funds are taxable funds that invest primarily in lower-credit-quality securities. (For more on issuer creditworthiness, see Bond ratings.) These can potentially provide income and total returns higher than investment-grade bond funds. However, these funds could also provide the potential for greater volatility and risk of loss.
High-yield bank loan funds invest primarily in floating rate loans (sometimes called "leveraged loans") issued by non-investment-grade companies. Loans are typically senior to bonds on the balance sheets of those issuers, and their coupons typically float above a common short-term benchmark, such as the London Interbank Offered Rate (LIBOR). This feature may provide some protection against rising rates, but like high-yield bonds, high-yield floating rate securities entail greater risk of loss than investment-grade counterparts.
While investing in high-yield securities isn't for everyone, these funds can complement the other investment-grade bonds as well as stock investments in your portfolio. Because high yield does not necessarily move in lockstep with either investment-grade bonds or stocks, adding this riskier asset category can help to diversify your portfolio and potentially improve its overall risk/return profile.
But remember these benefits, including the higher yields, come at a cost. Because the securities in high-yield portfolios may be issued by companies whose balance sheets are not as strong or by countries not on a firm financial footing, the interest payments and even the principal may be at risk, which could potentially result in more volatility and possible investment losses. Because of all of these factors, depending on your investment objectives, high-yield bond funds may not be appropriate at all or may only be appropriate for a portion of your fixed income portfolio.
Multisector funds invest in many different types of taxable bonds, with the portfolios varying by issuer, credit quality, average maturity, and average duration. So any given multisector fund could hold Treasury, corporate, and high-yield bonds. Some of them have a much larger allocation—35% to 65%—in riskier bonds such as high-yield corporate and municipal bonds, and bonds from emerging markets. These funds can be a good option for investors who are looking for one bond fund to represent the broadest possible diversification.
Some multisector funds are focused on a particular time horizon. For instance, short-term multisector funds tend to invest in more stable, shorter-term securities, such as U.S. Treasuries and agency bonds, and investment-grade corporate bonds. In return for greater stability, returns tend to be lower than average, which means the bonds tend to be more insulated from fluctuations in interest rates. Funds that focus on the longer-term might invest in a broader mix of securities issued by varying government and corporate entities both in the U.S. and overseas. The average maturities tend to be longer, meaning the value of these funds may fluctuate more in response to changes in interest rates.
Investors in higher tax brackets who want to generate income in a tax-efficient way may benefit from municipal bond funds. While these funds may offer lower yields, the income generated by the bonds in the portfolio is typically free from federal taxes. In addition, some funds invest in securities backed by projects in specific states, so depending on the individual investor's state of residence, the income may be free from state and local taxes as well. In general, because of their inherent tax advantage, municipal bond funds are not meant for retirement or other tax-advantaged accounts. Not all income from municipal bond funds is tax-free, though. Some interest income may be subject to the Alternative Minimum Tax. Plus, when a fund sells some of its underlying bonds, it can generate a distribution that fund shareholders could owe tax on. When you sell or exchange shares of a fund, that could also result in a capital gain or a loss for federal and state income tax purposes.
International & Global
International bond funds invest in a range of taxable bonds issued by foreign governments and corporations. Global bond funds invest in bonds from around the world, including bonds issued by U.S. government agencies and corporations. In addition to generating income, they help investors diversify by spreading interest rate and economic risk across a wider spectrum. International bond funds generally represent a slightly higher risk profile than funds holding bonds issued by the U.S. government and U.S. corporations, but they can also play a role in managing some of the risk associated with equity investing.