How to start investing in bond funds

Bond funds may help provide income, diversification, and capital preservation.

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Key takeaways

  • 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 bonds 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:

Generate income
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.

Preserve capital
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.

Manage volatility
Because issuers of bonds generally make interest payments and repay principal, investment-grade bonds can be less volatile than stocks. As a result, bonds can provide the potential for diversification, and help investors interested in lowering their portfolio volatility.

How bonds work

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.

Credit quality1
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 one of two credit quality categories:

Comparison chart of investment-grade bonds versus below-investment-grade bonds

See this Learning Center article on Fidelity.com for rating definitions.

Duration2
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 one of three duration categories:

Comparison chart of duration bonds

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 risk
U.S. government bond funds 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 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 U.S. government bonds of similar duration and credit quality. Although default risk is typically low, there are high-yield municipal bond funds that increase 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 U.S. 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 U.S. 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 U.S. issuers. Income potential is higher than U.S. government bonds, given the additional risks, and varies depending on the investment's duration. Risks similar to U.S. 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 U.S. 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 decline, 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 Evaluator and ETF Screener.

Mutual funds
Mutual fund evaluator > taxable bond, intermediate-term government bond, intermediate-term bond
ETFs
ETF screener > fixed income > blend, corporate, government issuer > investment grade credit quality, intermediate-term

Fidelity® Total Bond Fund (FTBFX

Fidelity® Investment Grade Bond Fund (FBNDX

Fidelity® Intermediate Treasury Bond Index (FIBAX)

Morgan Stanley Institutional Fund Trust Core Plus Fixed Income (MFXAX

Eaton Vance Core Plus Bond Fund Class A (EBABX

AB Income Fund Class A (AKGAX)

iShares iBoxx Dollar Investment Grade Corporate Bond ETF (LQD

iShares Intermediate Credit Bond ETF (CIU

SPDR Bloomberg Barclays Capital Intermediate Term Corporate Bond ETF (ITR

Vanguard Intermediate-Term Corporate Bond ETF (VCIT)


ETF results ranked by net assets; mutual funds by 3-year average annual returns. Top 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 August 7, 2017. 

If your goal is to increase income potential: Consider a high-yield bond fund or a multisector bond fund.

Given the current low interest-rate environment, 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 funds
Mutual fund evaluator > multisector and high yield bond funds
ETFs
ETF screener > ETFs > Fixed income > Corporate or blend issuer > Credit quality multi or high yield > Maturity intermediate, long, or multi

Fidelity® Capital & Income Fund (FAGIX

Fidelity® High Income Fund (SPHIX)

Fidelity® Global High Income Fund (FGHNX

Artisan High Income Fund Investor Shares (ARTFX

Invesco Multi-Asset Income Fund Class A (PIAFX

Lord Abbett High Yield Fund Class A (LHYAX)

iShares Core U.S. 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 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 August 7, 2017.



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 funds
Mutual fund evaluator > Taxable bond > Short-term bond, ultrashort bond, short government
ETFs
ETF screener > fixed income > short term or defined maturity > domestic objective > active management

Fidelity® Limited Term Bond Fund (FJRLX

Fidelity® Short-Term Bond Fund (FSHBX

Fidelity® Short-Term Treasury Bond Index Fund – Premium (FSBAX

Thompson Bond Fund (THOPX

Frost Total Return Bond Fund Investor (FATRX

PIMCO Low Duration Income Fund Class D (PFIDX)

Guggenheim Limited Duration Fund Class P (GILPX)

Guggenheim Ultra Short Duration ETF (GSY

First Trust Enhanced Short Maturity ETF (FTSM

Franklin Liberty Short Duration U.S. Government ETF (FTSD

PIMCO Enhanced Low Duration Active ETF (LDUR)

Fidelity Limited Term Bond ETF (FLTB


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 August 7, 2017.

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 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 funds
Mutual fund evaluator > municipal bonds > national short, intermediate, long
ETFs
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

Eaton Vance TABS 5-to-15 Year Laddered (EALTX

Sit Tax-Free Income Fund (SNTIX

Eaton Vance National Municipal Income Fund (EANAX)

iShares National AMT-Free Muni Bond ETF (MUB

PowerShares National AMT-Free Municipal Bond Portfolio (PZA

S&P Short Term National AMT-Free Bond ETF

Vanguard Tax-Exempt Bond Fund ETF (VTEB

PowerShares Build America Bond Portfolio (BAB)


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 August 7, 2017.

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.

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