For many investors, a bond fund is a more efficient way of investing in bonds than buying individual securities. Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are. Some bond funds aim to mimic the broad market, investing in short- and long-term bonds from a variety of issuers, such as the U.S. government, government agencies, corporations and other more specialized securities. Other bond funds focus on a narrower slice of the bond market, such as a short-term Treasury fund or a corporate high-yield fund.
Whether the fund’s mandate is broad or narrow, bond funds invest in many different securities—often buying and selling according to market conditions and rarely holding bonds until maturity—so it’s an easier way to achieve diversification even with a small investment. Income payments are made monthly, and reflect the mix of all the different bonds in the fund and the payment schedule of each. As such, the distribution may vary from month to month.
All mutual funds have operating expenses that include the costs of managing a fund. Some have sales charges, or loads, that are deducted from the amount of your initial investment. Some funds may charge a redemption fee for shares sold within a certain time period. Others may charge a small annual account fee. Make sure you are aware of all expenses before you invest.
Advantages of bond funds
Bond funds typically own a number of individual bonds of varying maturities, so the impact of any single bond’s performance is lessened if that issuer should fail to pay interest or principal. Certain types of bond funds, such as broad market bond funds, are also diversified across bond sectors, providing exposure to corporate, U.S. government, government agency and mortgage-backed bonds. The investment minimums for most bond funds are low enough that you can get significantly more diversification for much less money than if you purchased individual bonds.
Professional portfolio managers and analysts have the expertise and technology to research the creditworthiness of bond issuers and analyze market information before making investment decisions. Fund managers identify which securities to buy and sell through individual security analysis, sector allocation, and yield curve evaluation.
Liquidity and convenience
Bond funds allow you to buy or sell your fund shares each day. In addition, bond funds allow you to automatically reinvest income dividends and to make additional investments at any time.
Most bond funds pay regular monthly income, although the amount may vary with market conditions. This feature can make bond funds an appropriate choice for investors who desire somewhat stable, regular income. If you do not wish to receive the monthly income, you can choose to have your dividends reinvested automatically as one of several dividend options.
Potential for tax-free income
Many investors use municipal bond funds to help reduce their tax burden. Although municipal bond yields are generally lower than taxable bond fund yields, some investors in higher tax brackets may find they have a higher after-tax yield from a tax-free municipal bond fund investment instead of a taxable bond fund investment. Tax-free investments are usually not appropriate for tax-advantaged accounts such as IRAs.
Risks of bond funds
Interest rate risk
If interest rates rise, bond prices usually decline, and if interest rates decline, bond prices usually rise. This inverse relationship is important to understand. The longer a bond's maturity, the greater the bond’s interest rate risk. A bond fund with a longer average maturity will see its net asset value (NAV) react more dramatically to changes in interest rates as the prices of the underlying bonds in the portfolio increase or decline. The effect that interest rates have on the prices of bonds owned by the fund will cause the income that the fund distributes each month to vary.
Bond funds are typically classified as either investment grade quality (medium to high credit quality) or below investment grade quality, depending on the individual bonds in which they invest. (The bonds that funds own each carry the risk of default if the issuer is unable to make further income or principal payments.) Many individual bonds are rated by a third party rating agency such as Moody’s or Standard & Poor’s to help describe the creditworthiness of the issuer. Credit risk is a greater concern if the fund invests in lower-quality bonds such as high yield bond funds. The fund's prospectus will describe its credit quality policies.
When you sell shares in a fund, you receive the fund’s current net asset value (NAV), which is the value of all the fund’s holdings divided by the number of fund shares. If the fund’s NAV is lower on the day you sell shares than it was when you purchased them, you could lose some or all of your initial investment.
Other risks typically associated with bond investing, such as default risk and call risk, are mitigated because a bond fund is made up of many individual bonds. By owning a large number of bonds, the impact of any one bond defaulting or being called away prior to maturity (forcing the fund to reinvest the proceeds at a lower, prevailing rate of interest), is lessened.
Measuring bond fund performance
The performance of a bond fund is determined by the performance of its underlying investments, but there are a few factors specific to bond funds that will affect its performance and your investment. As with all investments, remember that past performance is not a guarantee of future results.
Every bond fund has a net asset value (NAV), or share price, which is the dollar value of one share of the fund. The NAV is based on the value of all the securities in the portfolio and typically fluctuates daily.
Yield of a bond fund measures the income received from the underlying bonds held by the fund. The 30-day annualized yield is a standard formula for all bond funds based on the yields of the bonds in the bond fund, averaged over the past 30 days. This figure shows you the yield characteristics of the fund's investments at the end of the 30-day period. It does not indicate the fund's future yield. The 30-day yield also helps you compare bond funds from different companies on a standard basis.
The tax-equivalent yield can help you objectively compare the yields of taxable and tax-free bonds or funds. The formula is used to calculate the tax-free yield you'd need to earn in order to get the same after-tax return, adjusted for your federal income tax bracket. The tax-equivalent yield will be higher for investors in higher tax brackets.
A bond fund's total return measures its overall gain or loss over a specific period of time. Total return includes income generated by the underlying bonds and (both realized and unrealized) price gains or losses. Investors should focus on total return when evaluating performance of bond funds.
Taxing mutual funds
Mutual fund investors, whether in bond funds or stock funds, may be subject to income taxes based on three different events when they invest in a fund outside of a tax-advantaged account, such as an IRA:
When the fund distributes dividend income—this is generally taxed at ordinary income tax rates.
When the fund distributes capital gains from the sale of securities—this could be taxed at ordinary income tax rates or the more favorable long-term capital gains rate, depending on how long the securities were held in the fund.
When you sell or exchange fund shares at a profit—those capital gains could also be taxed at ordinary income tax rates or the more favorable long-term capital gains rate.
Interest income generated by municipal bond funds is generally not subject to federal taxes, and may be tax-exempt at the state and local level as well, if the bonds held by the fund were issued by the state in which you live.