A bond fund, also known as a debt fund, is a type of investment that mainly focuses on bonds and other debt instruments like mortgage-backed securities. The main aim of a bond fund is usually to provide monthly income for investors.
Most investors have access to both bond mutual funds and bond exchange traded funds (ETFs).
Learn more about Bond fund
A bond fund is a type of mutual fund that exclusively invests in bonds. For numerous investors, a bond fund is a more effective method of investing in bonds compared to purchasing individual bond securities. Unlike individual bond securities, bond funds do not have a specific maturity date for the repayment of the initial investment, which means the invested amount may vary over time.
Investors also benefit from the interest earned on the bonds held in the mutual fund. The interest payments are distributed monthly and depend on the types of bonds in the fund, so the amount received may change each month.
When an investor puts their money into a bond fund, they are entrusting it to a portfolio manager who manages a pool of investments. Usually, the manager of a bond fund buys and sells bonds based on market conditions and seldom keeps them until they mature.
Some Types
Bond funds typically consist of specific types of bonds like corporate or government bonds, and are categorized by maturity timeframes like short-term, intermediate-term, and long-term.
Certain bond funds exclusively consist of the safest bonds, like government bonds. It’s important for investors to understand that U.S. government bonds are highly regarded for their top-notch credit quality and are not assigned ratings. Essentially, bond funds that focus on U.S. Treasury securities, including Treasury inflation-protected securities (TIPS), are the safest option but provide the lowest potential return.
Some funds focus on investing in the riskiest bonds, such as high-yield or junk bonds. These types of bond funds may provide higher potential returns due to the increased volatility.
There are bond funds that combine various types of bonds to offer multi-asset class options. Investors can use a Morningstar bond style box to categorize the investing options for bond funds. The available types of bond funds are: US government bond funds, municipal bond funds, corporate bond funds, mortgage-backed securities (MBS) funds, high-yield bond funds, emerging market bond funds, and global bond funds.
Benefits of Bond fund
Bond funds are a great choice for investors because they offer an easier way to invest compared to buying individual bond instruments. When investing in a bond fund, investors only need to pay the annual expense ratio, which covers marketing, administrative, and professional management fees. On the other hand, purchasing multiple bonds separately would involve dealing with transaction costs for each bond.
Bond funds offer immediate diversification to investors with a low minimum investment requirement. As these funds typically consist of a variety of bonds with different maturity dates, the negative impact of one bond’s performance is reduced if the issuer fails to make interest or principal payments.
A bond fund also offers the advantage of having skilled portfolio managers who can thoroughly examine the creditworthiness of bond issuers and market conditions. This enables them to make informed decisions when buying or selling bonds within the fund. For instance, if the issuer’s credit rating drops or if the issuer decides to pay off the bond early, the fund manager may choose to replace the bonds.
Considerations
Bond funds can be easily sold at any time based on their current market value, which could lead to a profit or loss. On the other hand, selling individual bonds may be more challenging.
Some investors in higher tax brackets may discover that investing in a tax-free municipal bond fund can provide them with a higher after-tax yield compared to a taxable bond fund investment, from a tax standpoint.
Long-term bonds have more interest rate risk compared to short-term bonds because of the inverse relationship between interest rates and bond prices. As a result, bond funds with longer-term maturities will be significantly affected by changes in interest rates, which will impact the net asset value (NAV) of the funds. Consequently, the amount of interest income that the fund can distribute to its participants on a monthly basis will also be affected.
Bond ETFs
Bond ETFs have not been in existence as long as bond mutual funds. The first bond ETF fund was introduced by iShares in 2002. While many of these options aim to mimic different bond indices, there are also an increasing number of actively managed products to choose from.
ETFs typically have lower fees compared to mutual funds, which can make them a more appealing option for certain investors, assuming all other factors are equal. Similar to stocks, ETFs can be traded throughout the day. The prices of ETF shares can change frequently and may experience significant fluctuations during trading.
Bond ETFs function similarly to closed-end funds. They are bought through a brokerage account instead of directly from a fund company. Similarly, when an investor wants to sell, ETFs need to be traded on the open market. Unlike open-ended mutual funds, the fund company does not buy the shares, so a buyer must be found.
Conclusion
A bond fund invests primarily in a portfolio of fixed-income securities. Bond funds provide instant diversification for investors for a low required minimum investment. Due to the inverse relationship between interest rates and bond prices, a long-term bond has greater interest rate risk than a short-term bond.