Want in on bonds but don’t know which to pick or where to start? Bond mutual funds could be worth exploring. When it comes to this type of investment, the name says it all. Just like a stock mutual fund invests in a basket of equities of numerous companies, a bond mutual fund invests in a number of government or corporate bonds.
Seems pretty simple, right? Well, if you’re interested in adding bond mutual funds to your portfolio, read on — because there’s plenty more to learn about the ins and outs of this type of investment.
Bond Mutual Fund Basics
A bond mutual fund usually invests in debt instruments issued by governments and/or corporations. Typically, most of these funds are designed to provide interest income to your portfolio in the form of dividends. These dividends represent the total interest payments made by all bonds in the fund’s portfolio.
Unlike the individual bonds within a bond fund, the fund itself is not structured to mature or be called by the issuer. Bond mutual funds have a fund manager, who keeps the fund going by adding new bonds to the portfolio as old ones mature or are sold. Because of this, you can’t be certain exactly how much you’ll receive if and when you decide to sell your fund shares — the amount could be higher or lower than your original investment. And that’s particularly true if a fund is facing a large number of investor redemptions, which can cause a fund to have to sell bonds even in instances where the manager might prefer not to.
Default risk is generally less with a bond fund than with an individual bond, because the risk is spread among a large number of bonds. Though diversification alone cannot guarantee a profit or ensure against a loss, if the issuer of one bond in a particular fund were to default, you wouldn’t lose your entire investment, which can happen with individual bonds.
Changing interest rates can also affect the value of a bond fund — even one that only includes bonds with stellar credit ratings. When interest rates and bond yields rise, the value of a bond fund is likely to drop. That’s because bond prices move in the opposite direction from yields. But a fund manager may be able to offset the impact by altering a fund’s duration (a gauge of the average length of time interest payments will be made on the bonds it contains). For example, if interest rates are rising, a fund manager might decrease the fund’s duration because higher rates would typically have less impact on the value of shorter-term bonds than on those with longer maturities.
Types of Bond Funds
A bond fund typically is either an open-end fund or a closed-end fund. Open-end funds issue new shares to accommodate new investors as money flows into the fund, and they stand ready to redeem shares when the investors want to sell. Closed-end funds issue a limited number of shares when the fund is established, and those shares trade on stock exchanges. A share may be priced either higher or lower than the fund’s net asset value, depending on investor demand for the fund.
You can choose from many varieties of bond funds. Each offers its own level of risk and potential return. While some bond funds invest in multiple bond types simultaneously, many focus their investments on a particular type (like high-yield bond funds or municipal bond funds). Many investors prefer to do their bond investing through a fund, because it can be challenging and time-consuming to research individual bonds.
If you aren’t sure which is right for you, consider consulting your financial planning professional to determine which types of bond funds are best for your particular circumstances and investment goals. And, before investing, carefully consider a fund’s investment objectives, risks, fees, and expenses. These can be found in the prospectus available from the fund. Read it carefully before investing, as you would with any mutual fund.
Take note: Dividends paid on bond mutual funds are technically interest, subject to tax at ordinary income tax rates. These dividends do not qualify for capital gains tax treatment under the Jobs and Growth Tax Relief Reconciliation Act of 2003. Please consult with a tax professional to determine how a bond fund investment can affect your taxes.
Short-term, Intermediate and Long-term Bond Funds
A bond fund can be categorized by its duration, which is based off the average maturities of the bonds it holds. While some funds hold bonds with a wide variety of maturities, others invest in bonds that have similar time frames (though that doesn’t mean they all come due at once) and may come from numerous issuers.
While precise guidelines for what constitutes short-term or intermediate can vary, a long-term bond fund typically holds bonds with maturities of 10 years or longer. An intermediate bond fund might hold bonds with maturities that range between three and 10 years. A short-term bond fund holds securities with maturities that are three years or less (some funds, sometimes called ultrashort-term funds, have an even shorter time frame).
In general, the shorter a bond fund’s duration, the lower its yield, because bond investors generally require a higher interest rate to lock up their money in longer-term debt instruments. The longer a bond fund’s duration, the greater the impact of changing interest rates. As mentioned earlier, bond prices move in the opposite direction of interest rates. So, when interest rates rise, bond prices fall and vice versa. That means the longer a fund’s duration, the more dramatic that motion can be. As you might assume, an intermediate bond fund falls somewhere between the relative stability of a shorter-term bond fund and the higher yields of a longer-term fund.
Bond Index Funds
A bond index fund attempts to match the performance of a standardized bond index by investing in a portfolio of bonds similar to that of the index. An index reflects changing market values and interest rates for bonds. This could be broad-based, like the Barclays Capital Aggregate Bond Index, or it might focus on a narrower segment of the bond market, such as intermediate bonds or investment-grade corporate bonds.
These are different than actively managed bond funds, which aim to outperform a given bond index through their managers’ selections of individual securities and the timing of bond purchases and sales.
As with any index fund, a bond index fund can be relatively cost-efficient, because it typically trades less often than an actively managed fund (which usually only changes when the index itself changes). Also, an index fund doesn’t require extensive research on individual bonds. Lower expenses can be especially important with a bond fund because bonds as an asset class normally offer lower returns than stocks.
Pro tip: Remember that even though a bond fund may come close to replicating an index, administrative expenses may mean it doesn’t match the index’s performance exactly.
Government Bond Mutual Funds
A government bond fund is made up of securities issued by the U.S. government and related entities like the Government National Mortgage Association (GNMA), for example. The U.S. government has never defaulted on a bond or redeemed one before maturity — which makes a government bond fund a relatively low-risk choice for conservative investors who seek a consistent stream of income. But keep in mind that while the government guarantees the securities that underlie a government bond fund, it doesn’t guarantee shares of the fund itself.
Government bond funds also offer a tax advantage, because their dividends are generally tax-exempt at the state and local (but not federal) levels. But because the default risk of a government bond fund is so low, your returns will usually be lower as well.
A specific type of government bond fund is one that specializes in Treasury Inflation-Protected Securities (TIPS). These funds adjust the principal and interest paid on an individual bond every six months to reflect changes in the Consumer Price Index (CPI). A TIPS-only government bond fund can be useful if rising inflation is anticipated — but if inflation is less over time than expected, a TIPS fund could have lower returns than an ordinary government bond fund.
A TIPS fund generally invests in bonds with a variety of maturities, and pays out not only the interest but any annual inflation adjustments to the bonds it holds. Like other government bond fund dividends, those payments are tax-exempt at the state and local level. Unlike an individual TIPS, which has a government guarantee that the repaid principal will never be less than your original investment if you hold it to maturity, you could receive less than your original investment when you sell your shares in a TIPS fund, as they don’t offer the same guarantee.
High-grade Bond Funds
A high-grade bond fund (a.k.a. an investment-grade bond fund) is primarily made up of bonds issued by U.S. corporations that have received a credit rating of AAA or AA from an investment rating service — although the term high-grade bond also may reflect U.S. Treasury bonds and other fixed-income securities.
The high-grade description is based on the perceived quality of the bonds. While even the most stable corporation could default on its bonds, typically, a bond that has been assigned a high grade is believed to have a relatively low chance of default.
Take note: Just remember that credit ratings apply only to the underlying bonds, not to the shares of a mutual fund that holds them.
For a little perspective, investment-grade bonds usually fall somewhere between the safety of U.S. Treasury bonds and high-yield corporate bonds that come with more risk. A high-grade bond fund can be used to provide current income or balance other more volatile components of a portfolio.
High-yield/Low-grade “Junk” Bond Funds
A high-yield/low-grade bond fund is made up of high-yield bonds (which you might hear being referred to as junk bonds) that have received a less-than investment-grade credit rating of BB or lower, depending on the investment rating service that issues the rating.
Bonds can earn junk bond status in many ways. The corporate issuer may be a small firm without a proven track record of sales and earnings. Or it could be a more established company that is currently experiencing financial difficulties. It could also be a company with a history of defaulting on or calling bonds (redeeming them before maturity). Basically, the common denominators among junk bonds are instability, uncertainty, and questionable credit strength.
To make up for the higher levels of risk involved, these kinds of bonds typically pay a higher-than-average yield. As the name suggests, a high-yield bond fund often will offer a higher-than-average dividend rate. This might make them more attractive to you if you’re seeking supplementary income and open to taking on greater risk. Also, because junk bond yields are more dependent on the quality of the issuer, opposed to other factors, they can sometimes be less affected by interest rate changes than investment-grade bonds are — giving your bond portfolio additional diversification.
When it comes to high-yield bonds, it can be particularly helpful to have a professional select bonds with the best risk-return profile (or the least amount of risk given the desired level of return). The diversification of a mutual fund may make sense especially in the case of investments that, by definition, are relatively high-risk. Finally, some junk bonds may be thinly traded, meaning you might face difficulty executing a trade or finding a buyer for a given bond. Though a fund could face similar challenges, it might have an easier time overcoming them than an individual investor with a single high-yield bond.
Tax tip: While dividends may provide income, they can also raise your income tax liability. If your fund lives up to the name high-yield and pays particularly large dividends, the tax consequences could be considerable — especially if you are in a high tax bracket. So, be sure to look at a fund’s after-tax returns and consult with your tax professional.
International and Global Bond Funds
An international bond fund invests in bonds issued by governments and/or corporations outside the United States. The types of bonds in the portfolio might vary. For example, some funds focus exclusively on foreign corporate debt, others focus on bonds issued by foreign governments (sovereign debt), and others strive for a mix of the two. An international bond fund might also focus on debt from developed countries, emerging markets, or a mix of both.
If you’re interested in investing in overseas markets, an international bond fund can help make it easier. In some cases, a fund may be the only way to access markets that are closed to noncitizens. A fund also provides international diversification. That’s because economic circumstances that affect one country or currency may not have the same impact on another.
A fund manager can choose from thousands of foreign bonds and can shift assets from country to country or from developed countries to emerging markets (and vice versa). Having some overseas bond investments can help balance a portfolio that is heavily invested in the United States, or one whose international investments are primarily equity-oriented. Finally, foreign debt that is perceived as being higher risk also may offer a higher interest rate.
Take note: Because global credit markets are now more tightly interconnected than ever before, international debt may suffer alongside U.S. credit markets in the event of any serious financial setbacks.
A global bond fund generally has a broader charter than an international fund. It may invest not only in foreign debt but also in bonds from U.S. issuers. Because of this, a global bond fund is typically more widely diversified than funds that don’t incorporate U.S. debt. Think of it this way: If the value of the dollar rises while the value of the yen plummets, a global bond fund with both U.S. and Japanese debt instruments will suffer smaller losses than a fund that invests largely in the Japanese bond market and holds no U.S. securities (though that also may limit the first fund’s gains if the Japanese bond market were to benefit from a weaker dollar).
Both international and global bond funds are subject to the risks involved with any overseas investment. This includes:
- Currency fluctuations. Changes in currency exchange rates can significantly affect returns from any foreign investment. Any foreign security held by an international or global fund will have been bought with the other country’s currency, making the security vulnerable to changes in the relative value of that currency. In general, the stronger the U.S. dollar, the worse an international bond fund will perform. In some cases, a fund may use sophisticated financial instruments to help hedge its exposure to currency risk. However, such hedges could also hamper a fund’s performance if exchange rates reversed course. To the extent that a global fund holds U.S. securities, it may assist in moderating the fund’s currency risk.
- Political and economic risk. Not all governments are as stable as the United States. Political and economic turmoil, particularly prevalent in emerging markets, can affect bond values and/or lead to defaults, even on sovereign debt.
These risks are in addition to the risks involved in any bond investment, like fluctuating interest rates, inflation/deflation, and the creditworthiness of the issuer.
Because of the unique operational requirements of researching and investing in foreign bonds, international and global funds may incur higher management and administrative expenses than other funds — which affects returns. Also, because these funds invest in foreign securities, they may have to pay income tax to the countries in which the bonds were issued. A fund passes this tax liability through to its individual shareholders on a pro rata basis. This foreign tax would be in addition to any U.S. taxes an investor might owe. However, a deduction or credit for foreign taxes paid may be available to some investors.
Tax-exempt and State Tax-exempt Bond Funds
A tax-exempt bond fund (sometimes referred to as a muni bond fund) is designed specifically to invest in bonds whose interest income is not subject to federal income taxes (generally municipal bonds).
A state tax-exempt bond fund typically invests in municipal bonds whose interest income is exempt from federal income tax and from state income tax for residents of states in which the bonds in the portfolio are issued. That might be a little confusing, so here’s an example: A New York tax-exempt bond fund would generally consist of municipal bonds issued in that state, which would be tax-exempt for residents of the state of New York.
Multisector Bond Funds
Just like the name implies, a multisector bond fund is designed to be a one-stop shop for access to a variety of bond types. Depending on the fund, a multisector fund might invest in corporate bonds (including high-yield junk bonds), international bonds, Treasury securities and mortgage-backed bonds, as well as other debt instruments. The fund might target a certain allocation for each category, but it may deviate from those targeted percentages, depending on which sectors the fund manager feels are positioned to do well. By holding multiple types of bonds — or in some cases, multiple types of other bond funds — a multisector bond fund has a great deal of flexibility to adjust to changing economic and market conditions.
Because of that flexibility, it’s important to understand a specific multisector bond fund’s investing parameters. Though it may seem strange given how broad their mandate typically is, multisector bond funds don’t necessarily correlate closely with the overall U.S. bond market. Returns are generally highly dependent on the manager’s decisions about not only individual securities, but about how the fund’s assets are allocated to the various sectors it covers. The percentage a fund typically devotes to, say, Treasury bonds, which carry relatively low risk, compared to junk bonds will affect both its returns and its volatility. Because a multisector bond fund demands expertise in a variety of debt instruments, a manager’s experience and acumen are especially important.
Convertible Bond Funds
Convertible bonds pay interest and also give you the right to convert a corporate bond into shares of the company’s stock. Because of that feature, convertible bonds and the funds that invest in them are affected not only by interest rates (as all bonds are), but also by changes in the associated stock prices.
A convertible bond fund is likely to benefit if stock prices rise, because the conversion feature on its bond holdings becomes more valuable (though a convertible bond usually is not as volatile as the company’s stock price). On the other hand, if stock prices fall, a convertible bond fund’s value could drop. Convertible bonds combine the income and relative price stability of bonds with the potential for capital appreciation.
A mutual fund streamlines the process of investing in convertible bonds. A fund may have a lower minimum investment than an individual bond. Also, the performance of mutual funds can be less challenging to compare than that of individual convertibles.
Bond Mutual Funds vs. Bond ETFs
It’s important to remember that while they have similarities, bond mutual funds and bond ETFs, or exchange-traded funds, are not the same. Both are basket-like securities that invest in numerous bonds, but ETFs and mutual funds have several fundamental differences. For example, bond ETFs trade throughout the day like stocks, whereas bond mutual funds only trade once per day at market close. ETFs and mutual funds also have differing tax implications, so it’s important to do your research and consult with your tax professional before investing in one or the other, so you can be prepared for how they may or may not impact your taxes.
While it’s important to find the balance of risk and reward with these dividend-paying investments, bond mutual funds can be a useful investment vehicle if you’re building a fixed-income portfolio. Whether you’re interested in investing in foreign markets, want in on a certain sector, or hope to get in on all corners of the bond market, get ready to start exploring bond mutual funds for your portfolio.