Bond Funds
There are four types of bond funds: Mutual funds, closed-end funds, unit investment trusts (UITs) and exchange traded funds (ETFs). While there are important distinctions between them, each type of fund allows an investor to instantly diversify risk among a pool of bonds at a low minimum investment. For those without a lot of money to invest, or who are investing through an employer-sponsored retirement plan, such as a 401(k) or 403(b) where mutual funds are the primary investment option, bond funds may represent the only realistic option to add this important asset class to your portfolio.
Before you invest in a bond fund, it is important that you understand the different fund types and how bond funds differ from individual bonds. For instance, one common misconception about bond mutual funds is that there is no risk to principal. This is not the case: Your initial and subsequent investments will fluctuate—and indeed may decline—just as they do if invested in a stock mutual fund.
Bond Mutual Funds
Mutual funds have become a preferred way to invest for millions of Americans. A mutual fund is simply a pool of money invested for you by an investment firm in a variety of instruments like stocks, bonds or government securities. Each mutual fund is different in its make-up and philosophy.
A bond mutual fund is a mutual fund that invests in bonds. Bond mutual funds can contain all of one type of bond (munis, for instance) or a combination of bonds. Each bond fund is managed to achieve a stated investment objective.
Like most investments, bond mutual funds charge fees and expenses that are paid by investors. These costs can vary widely from fund to fund or fund class to fund class. Because even small differences in expenses can make a big difference in your return over time, we’ve developed a fund analyzer to help you compare how sales loads, fees, and other mutual fund expenses can impact your return.
Before investing in a bond mutual fund, find out if it’s a load or no-load mutual fund. Load funds charge a sales commission; no-load funds do not. When you pay a sales commission going in, that’s called a front-end load. A commission paid when you sell is known as a back-end load. The fee table is generally found at the front of a mutual fund’s prospectus.
There are a number of reasons to consider bond mutual funds:
Types of Bond Mutual Funds
Actively Managed Bond Mutual Funds
The most common type of bond funds, open-end funds, are actively managed bond funds that allow you to buy or sell your share in the fund whenever you want. You buy and sell at a fund’s net asset value (NAV), which is the value or price per individual fund share and is priced at the end of each trading day—not throughout the day, as is the case with stocks.
Index Bond Mutual Funds
These funds are passively managed and are engineered to match the composition of a bond index, such as the Barclays Capital Aggregate Bond Index. Once the fund is constructed and trading, very little human intervention takes place; the fund’s performance is structured to track that of the index it mirrors.
Regardless of the type of bond mutual fund you select, keep these points in mind:
1. Return of principal is not guaranteed because of the fluctuation of the fund’s NAV due to the ever-changing price of bonds in the fund, and the continual buying and selling of bonds by the fund’s manager.
2. As with direct bond ownership, bond funds have interest rate, inflation and credit risk associated with the underlying bonds owned by the fund.
3. In contrast to owning individual bonds, there are ongoing fees and expenses associated with owning shares of bond funds.
4. As with individual bonds, you pay income tax on bond interest according to your tax bracket, not the 15 percent capital gains rate afforded to stock dividends in the 2003 Jobs and Growth Tax Relief Reconciliation Act. (See Understanding the Act on page 53.)
Beyond Bond Mutual Funds
Closed-End Bond Funds
Like bond mutual funds, closed-end bond funds are actively managed. However, a closed-end fund has a specific number of shares that are listed and traded on a stock exchange or over-the-counter market. Like stocks, shares of closed-end funds are based on their market price as determined by the forces of supply and demand in the marketplace. Shares may trade at a premium (above NAV) or, more often, at a discount (below NAV). Investors should be aware that closed-end funds may be leveraged, meaning the fund has issued or purchased stock or other investments using borrowed funds. While this leverage may result in increased yield during favorable market conditions, it could also result in losses if market conditions become unfavorable.
Visit FINRA’s website to read our investor alert, Closed-End Fund Distributions: Where is the Money Coming From.
Exchange-Traded Funds
An exchange-traded fund (ETF) is like a mutual fund, but trades on one of the major stock markets and can be bought and sold through a brokerage account throughout the trading day, like a stock. It can track a specific stock or bond index such as the S&P International Corporate Bond Index or be actively managed with a specific strategy in mind. And like stock investing, ETF investing involves principal risk—the chance that you won’t get all the money back that you originally invested.
Unit Investment Trusts
UITs, as they are referred to, are made up of a fixed parcel of bonds that are held in a trust and rarely change once the initial bond purchase is fixed, making it easier to estimate how much you will earn. UITs are passively managed funds. On the trust’s maturity date, the portfolio is liquidated and the proceeds are returned to unit holders in proportion to the amount invested. Unit holders who want to sell before maturity may have to accept less than they paid. While UITs are more diversified than an individual bond, they are generally far less diversified than a bond mutual fund. Each bond in the UIT has its own maturity date and often its own call provision as well, which can impact return and should be considered when estimating earnings. As each bond matures, or is called (UITs carry call risk), the principal is paid out to the shareholders until the last bond matures.
Bonds Versus Bond Funds
Individual bonds and bond funds are two very different animals. Understanding how bond funds and individual bonds differ will help you assess which is the best investment option for you. Here are four factors you should consider:
1. Return of Principal. Unless there is a default, when an individual bond matures or is called, your principal is returned. That is not true with bond funds. Bond funds have no obligation to return your principal. Except for UITs, they have no maturity date. With a bond fund, the value of your investment fluctuates from day to day. While this is also true of individual bonds trading in the secondary market, if the price of a bond declines below par, you always have the option of holding the bond until it matures and collecting the principal.
2. Income. With most fixed-rate individual bonds, you know exactly how much interest you’ll receive. With bond funds, the interest you receive can fluctuate with changes to the underlying bond portfolio. Another consideration is that many bond funds pay interest monthly opposed to semiannually, as is the case with most individual bonds.
3. Diversification. With a single purchase, a bond fund provides you with instant diversification at a very low cost. To put together a diversified portfolio of individual bonds, you’ll need to purchase several bonds, and that might cost you $50,000 or more. Most mutual funds only require a minimum investment of a few thousand dollars.
4. Liquidity. Virtually all bond funds can be sold easily at anytime at the current fund value (NAV).
The liquidity of individual bonds, on the other hand, can vary considerably depending on the bond. In addition to taking longer to sell, illiquid bonds may also be more expensive to sell.
Before You Invest
Here is our Top 10 list of things to consider before you invest in bonds or bond funds:
1. Define your objectives. Is your investment objective to have enough money for your child’s college education? Is your goal to live comfortably in retirement? If so, how comfortably? You probably have multiple goals. Lay them all out and be as precise as you can. Remember: If you don’t know where you’re going, you’ll never arrive.
2. Assess your risk profile. Different bonds and bond funds, like stocks and stock funds, carry different risk profiles. Always know the risks before you invest. It’s a good idea to write them down so they are all in plain sight.
3. Do your homework. You’re off to a good start if you’ve come this far—but keep going. Read books and articles about bond investing from the library. Look up information on the Web. Start following the fixed-income commentary on financial news shows and in newspapers. Familiarize yourself with bond math. You should also read the bond’s offering statement. It’s where you will find a bond’s important characteristics, from yield to the bond’s call schedule.
4. If you’re considering buying a bond fund, read the prospectus closely. Pay particular attention to the parts that discuss which bonds are in the fund. For instance, not all bonds in a government bond fund are government bonds. Also, pay attention to fees. Individual bonds also have prospectuses, which derive information from a bond’s indenture, a legal document that defines the agreement between bond buyer and bond seller. Ask your broker for a copy of the prospectus or indenture to read it.
5. If you’re buying individual bonds, locate a firm and broker specializing in bonds. Talk to a number of brokers, and find one you are satisfied with. Make sure your broker knows your objectives and risk tolerance. Check broker credentials and disciplinary history using FINRA BrokerCheck.
6. Ask your broker when, and at what price, the bond last traded. This will give you insight into the bond’s liquidity (an illiquid bond may not have traded in days or even weeks) and competitiveness of the pricing offered by the firm.
7. Understand all costs associated with buying and selling a bond. Ask upfront how your brokerage firm and broker are being compensated for the transaction, including commissions, mark-ups or mark-downs.
8. Plan to reinvest your coupons. This allows the power of compounding to work on your behalf. It’s a good idea to establish a “coupon account” before you start receiving coupons, so that you have a place to save the money and are not tempted to spend it. If you are buying a bond fund, you don’t have to worry about this—the fund does this for you.
9. Don’t try to time the market. As hard as it is to time the stock market, it’s even harder to time the bond market. Avoid speculating on interest rates. Decisions are too often made on where rates have been rather than where they are going. Instead, stick to the investment strategy that will best help you achieve your goals and objectives.
10. Don’t reach for yield. The single biggest mistake bond investors make is reaching for yield after interest rates have declined. Don’t be tempted by higher yields offered by bonds with lower credit qualities, or be focused only on gains that resulted during the prior period. Yield is one of many factors an investor should consider when buying a bond. And never forget: With higher yield comes higher risk.
Learning More about Bonds
Check out these resources to learn more about bonds and bond investing.