A bond fund is a mutual fund invested solely in bonds.
Many investors prefer bond funds versus buying individual bonds. Bond mutual funds are like stock mutual funds in that you combine your money with other investors and a professional invests it based on the best chances. Some bond funds try to replicate the performance of the market as a whole by investing in a wide range of bonds issued by entities as diverse as the United States Treasury, state and local governments, businesses, and money market funds. Short-term Treasury bond funds and corporate high-yield bond funds are two examples of specialized bond funds that invest only in those segments of the bond market where they see the greatest potential for growth.
Bond funds, regardless of their focus, invest in a wide range of bonds and other securities, trading in and out as market conditions dictate rather than keeping their holdings until maturity. Monthly payments reflect the fund's bond composition and payment schedules. Distribution may change from month to month.
Fund management fees are included in the operational expenditures of all mutual funds. Some contain sales costs that reduce your initial investment. A redemption fee is a cost that some funds impose when investors cash out their holdings before the end of a specified period. Others charge an annual fee. Know all costs before investing.
Advantages
Diversification
Because bond funds own several different bonds with variable maturities, the performance of any one bond is mitigated by the failure of the issuer to make interest or principal payments. Broad market bond funds, for example, invest in a wide variety of different bond types, such as government, agency, and mortgage-backed securities. Most bond funds have modest investment minimums, so you can diversify for less than if you bought individual bonds.
Management by professionals
Before making investing selections, professional portfolio managers and analysts use their experience and technology to examine the creditworthiness of bond issuers and analyze market data. Security analysis, sector allocation, and yield curve analysis are all tools used by fund managers to determine which assets to purchase and sell.
Money and ease
Bond funds allow daily buy/sells. Additional investments can be made at any time, and income dividends can be reinvested automatically in the bond fund.
Profits
Income from bond funds is typically paid monthly and may fluctuate based on market circumstances. This feature makes bond funds a good alternative for investors who want consistent, regular income. If you don't want a monthly income, you can have your dividends automatically reinvested.
Tax-free money
Municipal bond funds lower investors' tax burdens. However, investors in higher tax brackets may discover that their after-tax yield is better if they invest in a tax-free municipal bond fund rather than a taxable bond fund, despite the fact that the yield on municipal bonds is often lower than that of taxable bond funds. Tax-free investments aren't ideal for IRAs.
Disadvantages
Rate risk
Bond prices tend to fall as interest rates rise and to climb when interest rates fall. Observe this inverse relationship. Longer maturity increases interest rate risk. When interest rates rise or fall, the values of bonds in a bond fund's portfolio will rise or fall, causing the NAV of the fund to rise or fall more substantially. The influence of interest rates on the fund's bond values will change its monthly revenue.
Credit risk
Bond funds are classed as investment-grade or below-investment-grade depending on the bonds they invest in. (If the issuer of the bonds owned by the funds is unable to make future interest or principal payments, the bonds will go into default and the fund will lose all of its money.) Moody's or Standard & Poor's rates many bonds to describe the issuer's creditworthiness. If the fund buys lower-quality bonds, such high-yield bond funds, it will be more vulnerable to credit risk. The fund's prospectus describes its credit quality.
Main risk
The NAV of a mutual fund is the current market value of all of the fund's assets divided by the number of outstanding shares. If the fund's NAV is lower when you sell shares than when you bought them, you risk lose your initial investment.
Additional risks
Other bond investing risks, such as default and call, are minimized by a bond fund's many bonds. By owning many bonds, the impact of any one defaulting or being called before maturity, causing the fund to reinvest the profits at a reduced rate of interest, is lessened.
Performance
While a bond fund's performance is ultimately tied to that of its holdings, there are a few elements unique to bond funds that can have an impact on both its performance and your investment. Past performance is no guarantee of future outcomes.
Shares
Every bond fund has a NAV, or share price, which is the monetary worth of one share. The NAV fluctuates daily dependent on the portfolio's securities.
Yield
A bond fund's yield measures income from underlying bonds. The 30-day annualized yield is a typical calculation for bond funds based on the bonds' 30-day average yields. This chart illustrates the fund's 30-day yield. It doesn't show fund yield. The 30-day yield helps compare bond funds across corporations.
Taxable yield
Tax-equivalent yield lets you compare taxable versus tax-free bonds or ETFs. You can use the method to determine the after-tax yield you would need to earn from a tax-free investment in order to achieve the same after-tax return as the investment in question, after taking into account your personal income tax bracket. Higher tax brackets have higher tax-equivalent yields.
Total return
Bond fund total return measures overall gain or loss over time. Total return comprises bond income and price gains (realized and unrealized). Bond fund investors should consider total return.
Taxes
Investors in bond funds and stock funds alike who do not use a tax-deferred account like an individual retirement plan (IRA) may be subject to income taxes on their investments for three reasons.
- Fund dividend income is taxed at ordinary income rates.
- Depending on how long the securities were kept in the fund, capital gains on the sale of securities may be taxed at ordinary income rates or the more favorable long-term capital gains rate.
- When you sell or swap fund shares for a profit, you may be taxed at regular income rates or the preferable long-term capital gains rate.
To the extent that the bonds held by the fund were issued by the state in where you reside, the interest income generated by the fund may be free from state and local taxes as well.