Understanding Bond Funds
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Definition
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Bond funds invest in various types of fixed-rate debt securities with the aim of maximizing the income from the capital provided by investors. As with other mutual funds, investors buy shares in the fund at a price determined by the fund's NAV (net asset value) divided by the number of outstanding shares. Most bond funds pay a monthly dividend based on the interest earned by the securities in the fund portfolio. The most common types of bond funds are those that invest in government or in corporate bonds. Some bond funds focus on long-term bonds while others invest in those with short maturities (referred to as ultra-short and money market funds).
Government Bond Funds
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Funds that specialize in government-issued bonds appeal primarily to investors looking for minimal risk and/or tax exempt income. Some funds hold Treasury securities of various types. The term "Treasury bond" is normally reserved for federal bonds with maturities of 10 years or longer. Treasury notes are shorter term (as little as one year) while T-bills bought by bond funds trading in the money market have maturities of less than a year. Some funds invest in TIPS (Treasury Inflation Protected Securities). TIPS are bonds whose face value is adjusted annually to offset inflation. Some bond funds invest in state and local bonds (collectively called municipal bonds) because interest paid is usually exempt from federal income tax. Government bonds of any type are considered low risk and consequently so are the funds that invest heavily in them.
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Corporate Bond Funds
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Corporate bond funds generally have the highest dividends because the debt securities they hold pay higher interest rates (although they don't come with tax advantages). Corporate bonds are rated by financial services firms such as Standard & Poor's based on credit risk, with AAA-rated bonds being the safest. Investors should look at the average rating of the bonds a fund holds to assess the risk of the fund itself. Another factor to consider is the presence of "callable" corporate bonds in the fund portfolio. These bonds can be redeemed early, and corporations are prone to do so if interest rates fall, forcing the bond fund to switch to lower yield bonds and reducing dividends.
Money Market Funds
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Very short-term bonds (less than one year) are used by governments and corporations alike to cover current expenses. These bonds trade on the money market separately from debt securities with longer maturities. Bond funds that invest in the money market are generally similar to other bond funds, but with some exceptions. First, the bonds are extremely safe because their short maturities don't allow time for major shifts in interest rates or bond prices to significantly affect yields. Second, money market bond funds usually market to investors through money market accounts that provide moderate earnings combined with easy access to the money invested (you can even write checks on a money market account).
Risk
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Bond funds are not without risk, although they are safer than stock mutual funds aimed at equity growth. The principal concern for investors is interest rate risk. When prevailing interest rates rise, bond prices fall. This reduces the NAV of a bond fund and hence the investor's equity. Conversely, if interest rates fall, bond prices tend to rise, increasing equity but tending to reduce yields and therefore the dividends paid by the bond fund. Credit risk and the chance callable bonds may be redeemed early (discussed above) are other factors an investor should consider. Finally, some bond funds invest in international debt securities. These carry a special risk because changes in foreign currency exchange rates can impact the value of the bond fund's assets and dividends.
Selecting Bond Funds
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Like all mutual funds, bond funds are regulated by the Securities and Exchange Commission, which requires the fund to provide investors with a prospectus updated annually. The prospectus discloses the fund's performance history, fee structure and management record. This is where a prospective investor should start when evaluating a bond fund as a possible investment. Independent analysis of bond funds is readily available as well from financial research firms such as Morningstar (Morningstar.com) and Crane Data (cranedata.us).
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