Bond funds contain thousands of individual bonds issued by governments, corporations and mortgage companies. Investors who primarily seek income from their investment holdings buy bond funds all the time but there are times when bonds become attractive to investors. Bonds are particularly attractive during stock market downturns, when inflation risks are low, and some bonds funds are very attractive when taxes are rising.
When the stock market experiences a downturn, investors begin to sell off shares and this causes stock prices to fall even further. Investors can either take the cash or move their money from mutual funds containing primarily stocks to conservative mutual funds such as bond funds. People who move money between funds operated by the same investment company do not usually have to pay commissions. Bonds are much less volatile than stocks, which means mutual funds holding bonds are not as impacted as stock funds during market downturns. Therefore, many people use bond funds as safe harbor investments meaning that stock market downturns are a good time to buy bond funds.
Bonds are issued with terms lasting for between six months and 30 years. Most bonds pay a fixed yield, which means that over extended periods of time, inflation can erode the spending power of bond holders if the inflation rate exceeds the bond's interest rate. People should not buy bonds when inflation becomes a concern but during periods of relatively low inflation, or even deflation. Bond funds are often a good investment because the rates on older bonds are better than yields offered on newly issued securities.
The federal government does not assess ordinary income tax on interest earned on most types of municipal bonds. States do not assess income tax on interest earnings on in-state bonds. Generally, municipal bonds pay lower rates of interest than taxable bonds because of the tax savings. However, when taxes rise, municipal bonds become more attractive, and increasing numbers of investors buy municipal bond mutual funds, which causes the price of each share to rise. Therefore, many savvy investors buy large numbers of shares in municipal bonds just prior to tax increases taking effect.
When large institutional investors sell off huge numbers of bonds in order to raise cash, it can cause the bond market to become flooded. This temporarily drives down prices and enables investors to buy bond fund shares cheaply. When the default rates on any particular type of bonds suddenly increase, it normally has a knock-on effect that causes investors to sell off other types of bonds.
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