What is the bond fund?
A bond fund, also called a debt fund, invests primarily in bonds (government, municipal, corporate, convertible) and other debt instruments, such as mortgage-backed securities (MBS), for the primary purpose to generate monthly income for investors. Many times 401k are linked to bond funds.
Key points to remember
- A bond fund, also called a debt fund, invests primarily in bonds (government, corporate, municipal, convertible) and other debt instruments, such as mortgage-backed securities (MBS), for the primary purpose to generate monthly income for investors.
- Bond funds offer instant diversification to investors for a low minimum required investment.
- Because of the inverse relationship between interest rates and bond prices, a long-term bond presents a higher interest rate risk than a short-term bond.
Introduction to bond investing
Understanding the bond fund
A bond fund is simply a mutual fund that invests only in bonds. For many investors, a bond fund is a more efficient way to invest in bonds than to buy individual bond securities. Unlike individual bond securities, bond funds do not have a maturity date for the return of capital, therefore, the capital invested may vary from time to time.
In addition, investors indirectly participate in the interest paid by the underlying bond securities held in the UCI. Interest payments are made monthly and reflect the combination of all of the fund’s different obligations, which means that the distribution of interest income will vary monthly. An investor who invests in a bond fund puts his money in a pool managed by a portfolio manager. Generally, a bond fund manager buys and sells on market terms and rarely holds bonds until maturity.
Most bond funds are made up of some type of bond, such as corporate or government bonds, and are defined by time to maturity, such as short term, medium term and long-term. Some bond funds only include secure bonds, such as government bonds. Investors should note that US government bonds are considered to have the best credit quality and are not subject to ratings. Indeed, bond funds specializing in US Treasury securities, including Treasury Inflation Protected Securities (TIPS), are the safest, but offer the lowest potential return.
Other funds invest only in the riskiest bond category, that is, high yield bonds or garbage. Bond funds that invest in more volatile types of bonds tend to offer higher potential returns. However, other bond funds have a mix of different types of bonds to create multi-asset class options. For investors interested in bonds, a Morningstar bond style box can be used to sort the investment options available for bond funds. The types of bond funds available include: U.S. government bond funds, municipal bond funds, corporate bond funds, mortgage-backed securities funds (MBS), high yield bond funds, bond funds emerging markets and global bond funds.
Benefits and risks of bond funds
Bond funds are attractive investment options because they are generally easier for investors to participate in than buying the individual bond instruments that make up the bond portfolio. By investing in a bond fund, an investor only has to pay the annual expense ratio which covers the costs of marketing, administration and professional management, compared to the purchase of several bonds separately and the costs of transaction associated with each.
Bond funds offer instant diversification to investors for a low minimum required investment, since a fund generally has a pool of different bonds of different maturities, the impact of the performance of a single bond is diminished if this issuer does not pays no interest or principal.
Another benefit of a bond fund is that it provides access to professional portfolio managers who have the expertise to research and analyze the credit worthiness of bond issuers and market conditions before buying or selling the bond. funds. For example, a fund manager can replace bonds when the issuer’s credit is downgraded or when the issuer “calls” or redeems the bond before the maturity date.
Bond funds can be sold at any time for their current net asset value (NAV), which can result in a capital gain or loss. Individual bonds can be more difficult to discharge. From a tax perspective, some investors in higher tax brackets may find that they have a higher after-tax return from an investment in a non-taxable municipal bond fund instead of an investment in a taxable bond fund.
Because of the inverse relationship between interest rates and bond prices, a long-term bond presents a higher interest rate risk than a short-term bond. Consequently, the net asset value of bond funds with longer maturities will be strongly affected by changes in interest rates. This, in turn, will affect the amount of interest income that the fund can distribute monthly to its participants.