- Bond funds can play an important role in a portfolio.
- Fixed income investments can provide regular income, diversification from stock risk, and principal protection.
- There are many different kinds of bond funds, and an appropriate choice is based on your particular goals and situation.
When it comes to investing, many people start with stocks. And while most investors understand the benefits of diversification, the role of bonds and how they work can still be confusing. So here are the basics of bonds and bond funds: the different types, how to use them, and some ideas on how to find appropriate bond investments for different goals.
Bonds may help provide income and stability
Bonds are securities that are similar to loans. They are issued by governments and corporations around the world to finance new projects, maintain ongoing operations, or refinance other debts. The issuer typically makes regular interest payments, and repays the full investment at the end of a set period of time, at which point the bond typically reaches "maturity" and the investor's principal is returned, plus any accrued interest.
Bonds can provide important potential benefits in a diversified portfolio:
The interest payments that bonds offer can help investors build an income stream that can be reinvested or used to manage cash-flow needs—either supplementing existing income or creating a source for income in retirement.
Repayment of the original investment in the bond can help provide reassurance to investors who are concerned about protecting capital or meeting intermediate-term financial needs, such as college tuition or a down payment on a new home. For more immediate financial needs, cash savings, money markets, or other short-term options may be more appropriate. For longer-term goals, investment opportunities with more growth potential may make more sense. Of course, repayment of the original investment depends on the financial health of the issuer.
Because issuers of investment-grade bonds generally have the financial strength to make interest payments and repay principal, investment-grade bonds can be less volatile than stocks. What's more, bonds may perform well during times when stocks struggle, and as a result, bonds can provide the potential for diversification, and help investors interested in lowering their portfolio volatility.
Individual bonds versus bond funds
Many investors approach the bond market through bond mutual funds and ETFs, both of which can provide diversification and professional management. Bond funds differ from individual bonds in that most bond funds and ETFs have no set maturity date for the repayment of principal, and offer somewhat less principal protection.
How to evaluate bonds
Although most types of bonds share some common features, such as a fixed interest rate and a maturity date, they are not all equal in terms of income potential and risk. Two important bond measurements—credit quality and duration—can give you a good indication of the income you might receive and the risk you are taking on to pursue that income.
A bond's credit quality indicates the likelihood that its issuer will fulfill its obligation to pay the interest owed and repay the principal at maturity. It is assigned by credit rating agencies that analyze the security and the financial soundness of the issuing company. Bonds generally fall into 1 of 2 credit quality categories:
In general, as interest rates rise, existing bond prices usually fall, and vice versa. But these changes do not affect all bonds equally. Duration measures the sensitivity of a bond's price to changes in interest rates. It is influenced greatly by the length of time until the bond's maturity date. Interest rates also influence duration—the higher the interest rate, the lower the duration. Bonds generally fall into 1 of 3 duration categories:
The universe of bond funds
Bonds from different issuers may be grouped into general categories. Within these categories there may be more- or less-risky options, and understanding these subsets of the bond market may help you find appropriate investments for your strategy. Some funds, ETFs, and managed accounts combine these different categories of bonds to create multi-asset class options.
|Issued by||Income potential||Credit and interest rate risk|
|US government bond funds||Bonds issued or guaranteed by the US government, such as Treasury bonds and bills, as well as mortgage- and other asset-backed securities backed by government agencies.||Income potential tends to be lower than other bonds of similar maturities, and varies depending on duration.||Lowest credit risk relative to other issuers/markets, but interest rate risk depends on the investment's duration.|
|Municipal bond funds||Bonds issued by cities, states, and other local government entities to build schools, highways, and many other projects for the public good.||Because income is usually exempt from federal and, in some cases, state and local income taxes, after-tax income potential may be higher than government bond funds of comparable quality and duration. Also, income potential varies depending on the investment's duration and the quality of its bonds.||Municipalities have more risk than US government bonds of similar duration and credit quality. Although default risk is typically low, there are high-yield municipal bonds funds, which have increased credit risk. Interest rate risk depends on the fund's duration.|
|Corporate bond funds||Investment-grade bonds issued by corporations to expand, modernize, cover their expenses, and finance other activities.||Income potential is generally higher than that paid by US government bonds of similar duration and varies depending on the fund's duration and the quality of its bonds.||Although many have moderate credit risk, there are high-yield options that increase default risk (see high-yield bond funds). Interest rate risk depends on the fund's duration. May also invest in other fixed income securities, like US government and mortgage-backed securities.|
|High-yield bond funds||Primarily bonds that are issued by corporations facing adverse or uncertain business, financial, or economic conditions.||Income potential is higher than investment-grade bonds to offset the high level of default risk.||High credit risk and history of significant price volatility, especially relative to higher-quality bonds. Interest rate risk may be lower than some bonds as the investment's pricing tends to move in the same direction as stocks. May also invest in other high-yield assets, like bank loans, preferred securities, and convertible bonds.|
|International and global bond funds||Taxable bonds issued by foreign governments and corporations. The global bond category may also include US issuers.||Income potential is higher than US government bonds, given the additional risks, and varies depending on the investment's duration.||Risks similar to US bond investments, and additional risks include currency risk and country/political instability.|
|Emerging-market bond funds||Bonds from developing countries around the world.||Income potential is higher than US and developed nation bond funds, given the additional risks and longer durations.||More likely to experience higher volatility due to sharp economic swings, political upheaval, and other disruptions not typically found in countries with more established financial markets.|
Matching bond investments to needs
With all the different types of bond funds available to you, how do you determine an appropriate investment for your strategy?
Like many investment decisions, the process starts with your specific investment goals, time horizon, and tolerance for risk. Here are some general guidelines: You will need to determine if they apply and how they are relevant to your individual situation.
If your goal is to help protect against stock market downturns: Consider investment-grade, intermediate-term bond funds (also known as core bond funds) or ETFs.
Including a core bond fund in your investment mix may reduce your portfolio's overall volatility—and can also help moderate your natural anxiety during stock market downturns.
A core investment-grade bond fund may provide:
- Lower volatility than most stocks and high-yield bond funds due to more reliable income sources and lower default risk
- Downside protection—high-quality bonds have tended to outperform the stock market during downturns, when many investors are attracted to a bond fund's income stream and principal protection
On the other hand, core investment-grade bonds may suffer price losses if rates rise, and may lose value in an inflationary environment.
Here are some illustrative examples of these bond funds. You can screen for your own, see the complete results of these screens, and change the criteria using the mutual fund eEvaluator and ETF screener.
Mutual fund evaluator > taxable bond, intermediate-term government bond, intermediate-term bond
ETF screener > fixed income > blend, corporate, Federal/Central debt issuer > investment grade credit quality, intermediate-term
Fidelity® Total Bond Fund (FTBFX)
Fidelity® Investment Grade Bond Fund (FBNDX);
Fidelity® Intermediate Bond Fund (FTHRX)
Eaton Vance Core Plus Bond Fund Class A (EBABX)
Morgan Stanley Institutional Fund Trust Core Plus Fixed Income (MFXAX)Morgan Stanley Mortgage Securities (MTGAX)
Fidelity Corporate Bond ETF (FCOR)
Fidelity Total Bond ETF (FBND)
iShares iBoxx Dollar Investment Grade Corporate Bond ETF (LQD)
Vanguard Intermediate-Term Corporate Bond ETF (VCIT)
iShares Intermediate-Term Corporate Bond ETF (IGIB)
SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB)
ETF results ranked by net assets; mutual funds by 3-year average annual returns. Top overall results and top Fidelity results shown. For mutual funds, top Fidelity funds and non-Fidelity funds shown. Please use the evaluator/screener to see the full and up-to-date list of results and modify the criteria. Results as of Nov. 29, 2018.
If your goal is to increase income potential: Consider a high-yield bond fund or a multisector bond fund.
Adding a high-yield allocation to your core bond portfolio or investing in a multisector bond fund may help increase your investment income—just remember that many of these types of funds still come with the potential for significant volatility, particularly during times of heightened economic and/or stock market volatility.
A high-yield or multisector bond fund may provide:
- Income potential from a broader fixed income universe by diversifying into bonds that may react differently to economic and interest rate changes
- Exposure to a range of durations and credit qualities
Mutual fund evaluator > multisector and high-yield bond funds
ETF screener > ETFs > Fixed income > Corporate or blend issuer > Credit quality multi or high-yield > Maturity intermediate, long, or multi
Fidelity® High Income Fund (SPHIX)
Fidelity® Capital & Income Fund (FAGIX)
Fidelity® Global High Income Fund (FGHNX)
DDJ Opportunistic High-Yield Fund Class II (DDJRX)
Artisan High Income Fund Investor Shares (ARTFX)
T. Rowe Price Global High Income Bond (RPIHX)
Fidelity High Yield Factor ETF (FDHY)
Fidelity Total Bond ETF (FBND)
iShares Core US Aggregate Bond ETF (AGG)
Vanguard Total Bond Market ETF (BND)
iShares iBoxx Dollar High-Yield Corporate Bond ETF (HYG)
ETF results ranked by net assets; mutual funds by 3-year average annual returns. Top results overall, and for Fidelity funds, are shown. For mutual funds, top Fidelity and non-Fidelity funds shown. Please use the evaluator/screener to see the full and up-to-date list of results and modify the criteria. Results as of Nov. 29, 2018.
If your goal is to meet an approaching financial target: Consider a short-term, investment-grade bond fund or an investment-grade defined maturity bond fund.3
Investing in a high-quality short-term bond fund or a defined maturity fund (DMF) may help limit large fluctuations in your investments as you get closer to your goal. A DMF is designed to distribute its net asset value to shareholders in cash shortly after the fund's end date. Consequently, unlike traditional bond funds, a DMF's price sensitivity to changes in interest rates declines gradually over time, approaching zero near its target end date. (Defined maturity funds are not designed for investors seeking stable value or guaranteed income.)
A short-term bond fund or a defined maturity fund may provide:
- Less sensitivity to interest rate changes than equivalent intermediate- or long-term funds
- Lower default risk than high-yield bond funds
Mutual fund evaluator > taxable bond > short-term bond, ultrashort bond, short government
ETF screener > fixed income > short term or defined maturity > domestic objective > active management
Fidelity® Conservative Income Bond Fund – Premium (FCONX)
Fidelity® Limited Term Bond Fund (FJRLX)
Fidelity® Short-Term Bond Fund (FSHBX)
PIMCO Low Duration Income Fund Class A (PFIAX)
Thompson Bond Fund (THOPX)
Morgan Stanley Institutional Fund Trust Short Duration Income Portfolio Class A (MLDAX)
JPMorgan Short Duration Core Plus (JSDHX)
Fidelity Limited Term Bond ETF (FLTB);
First Trust Enhanced Short Maturity ETF (FTSM)
Invesco Ultra Sshort Duration ETF (GSY)
Janus Short Duration INCOME ETF (VNLA)
PIMCO Low Duration ETF (LDUR)
Franklin ShortDuration US GOVERNMENT ETF (FTSD)
ETF results ranked by net assets; mutual funds by 3-year average annual returns. Top results overall, and for Fidelity products, are shown. For mutual funds, top Fidelity and non-Fidelity funds shown. Please use the evaluator/screener to see the full and up-to-date list of results and modify the criteria. Results as of Nov. 29, 2018.
If your goal is to seek an overall tax advantage: Consider an investment-grade municipal bond fund with income that is usually exempt from federal income tax.4
Investing in a high-quality municipal bond fund may help you keep more of what you earn if you are an investor in a higher federal tax bracket or a resident of a high-tax state. However, munis may pay pre-tax lower yields than Treasury or corporate bonds of similar maturity and quality, and are subject to the same rate risks as other bonds.
A municipal bond fund may provide:
- Tax advantages with income that is typically exempt from federal and, in some cases, state and local income taxes4
- Lower default risk than high-yield municipal funds
Mutual fund evaluator > municipal bonds > national short, intermediate, long
ETF screener > fixed income > municipal issuer > investment grade
Fidelity® Tax-Free Bond Fund (FTABX)
Fidelity® Municipal Income Fund (FHIGX)
Fidelity® Municipal Income 2023 Fund (FCHPX)
BlackRock Strategic Municipal Opportunities Fund (MEMTX)
Sit Tax-Free Income Fund (SNTIX)
Goldman Sachs Dynamic Municipal (GSMIX)
iShares National AMT-Free Muni Bond ETF (MUB)
Vanguard Tax-Exempt Bond INDEX ETF (VTEB)
iShares S&P Short Term National AMT-Free Bond ETF (SUB)
Investo National AMT-Free Municipal Bond ETF (PZA)
ETF results ranked by net assets; mutual funds by 3-year average annual returns. Top results shown. For mutual funds, top Fidelity and non-Fidelity funds shown. Please use the evaluator/screener to see the full and up-to-date list of results and modify the criteria. Results as of Nov. 29, 2018.
The bottom line
Bond funds can play an important role in your investment strategy by helping to deliver income, offset some of the stock market risk in your portfolio, and preserve your savings. The bond market has lots of different investment options. To understand the type of bonds that might work for you, start with your investment strategy and make use of Fidelity's screening tools to find ideas.
Or, if you don't have the skill, will, or time to do the research, consider professional management through a managed account.
Next steps to consider
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