Mutual Funds: About Bond Funds
Bond Fund Basics
There are many different types of bonds. Thus, there are many different types of bond funds. As a result,
risk and rewards for bond funds vary dramatically.
Bonds are a way governments and companies raise money. They are an IOU. The issuer of the bond (the borrower) promises to pay back
the principal (the original investment) plus interest. Bonds have a maturity date when they are due. Bonds are bought and sold
during their life. Their value rises and falls as interest rates change and as corporate finances change.
Bond funds invest in the bonds of many different bonds, spreading risk and, hopefully, increasing reward.
In general, bond funds:
- have higher risks than money market funds. (Just about any uninsured investment has greater risk than a money market
fund.)
- seek to pay higher yields than money market funds
- are not restricted to high-quality or short-term investments like money market funds
Investors often buy bond funds for income, often in retirement, and to diversify (balance) a portfolio.
Types of Bond Funds
The general types of bond funds are:
- U.S. Government Bond Funds — invests in U.S. treasury or government securities. Pays interest which provides
safe, steady income. These funds do best when interest rates are falling. To get higher returns, some funds of this type
invest in other securities including corporate bonds.
- Municipal Bond Funds — invests in tax-exempt bonds issued by state and local governments to fund projects
such as building roads, hospitals and schools. Income earned can be non-taxable, depending on where you live and your
income tax filing requirements.
- Mortgage-Backed Securities Funds — invests in securities representing residential mortgages. Generally have
appealing yields. Generally carry a little more risk than a Treasury bond fund, but less risk than a corporate bond fund.
- Corporate Bond Funds — invests in bonds (debt obligations) of corporations. Higher risk than U.S. Government
or Municipal Bond funds, but higher reward. Corporate bond funds vary alot. Pick the ones that match your
investment goals and tolerance for risk. Investment-grade corporate bond funds invest in companies with the
best credit ratings and are the safest of this type. “High yield” (high income) funds invest in riskier companies.
Bond funds can also be classified by maturity (the date the issuer of the bond must pay back the money borrowed). Under this
system, bonds are grouped into short-term bonds, intermediate-term bonds or long-term bonds.
Long-term bond funds invest in bonds with longer maturities (length of time until the final payout). The values (NAVs) of
long-term bond funds can go up or down more rapidly than those of shorter-term bond funds.
Risks With Bond Funds
Bond funds carry these types of risk:
- Credit risk — the risk that the issuer of the bond does not pay their debts, including the debt owed to the
mutual funds that hold the bonds. Bond funds that invest in U.S. Treasury bonds or other insured bonds have little
credit risk. Bond funds that invest in corporate “junk bonds” have high risk. Many bond funds fall between
these two extremes.
- Interest risk — the risk that the market value of the bonds will go down when interest rates rise. This is a
risk that all bond funds carry. Interest rate risk means that you can lose money even in funds that invest in
insured or Treasury bonds. Bond funds that invest in longer-term bonds have higher interest rate risk.
- Prepayment Risk — the risk that a bond will be paid off (retired) early. Some companies do this when
interest rates fall so they can issue new bonds that pay a lower rate.
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