A bond fund is a mutual fund or an exchange-traded fund (ETF) that invests in a diversified portfolio of debt instruments such as government and corporate bonds. The primary objective of a bond fund is to generate consistent income for investors on a monthly basis.
For an investor, a bond fund offers an alternative to purchasing individual bonds, providing a chance to buy shares in a fund that encompasses numerous bonds. Typically, a bond fund manager buys and sells these bonds based on market conditions, rather than holding them until maturity.
Key Takeaways
- A bond fund invests primarily in a portfolio of fixed-income securities such as municipal and corporate bonds.
- Bond funds offer diversification for investors for a relatively low minimum investment.
- Due to the inverse relationship between interest rates and bond prices, long-term bonds carry greater interest rate risk than short-term bonds.
The Efficiency of Investing in Bond Funds
For many investors, bond funds are a more efficient means of investing compared to acquiring individual bond securities. Unlike individual bond securities, bond funds do not have a set maturity date for the repayment of principal, meaning the principal amount can fluctuate.
Investors in bond funds receive monthly payments that represent the blend of all bonds in the fund. This means that interest payments will vary monthly.
Understanding “AAA” Ratings
Bonds are graded based on the likelihood that the issuer will default on their debt obligations. An “AAA” or “AA” rating signifies that the bond is issued by a highly reliable company or government, whereas an “F” rating indicates a high risk of default.
Types of Bond Funds
Bond funds typically consist of specific types of bonds, such as corporate or government bonds, and may be focused on varying times to maturity, including short-term, intermediate-term, and long-term bonds.
Investors can select bond funds that only purchase the highest-quality, safest bonds, such as U.S. government bonds or bonds from blue-chip companies. High-quality bonds tend to offer lower interest rates compared to riskier bonds.
It’s worth highlighting that U.S. government bonds are often considered the highest credit quality. Bond funds specializing in U.S. Treasury securities, including Treasury inflation-protected securities (TIPS), are among the safest options but offer lower potential returns.
Exploring Riskier Options
Some funds target investing solely in high-yield or junk bonds, offering higher returns parallel with a higher risk of default by the issuers.
There are also mixed bond funds that encompass various types of bonds to create multi-asset class options. Among the types available are US government bond funds, municipal bond funds, corporate bond funds, mortgage-backed securities (MBS) funds, high-yield bond funds, emerging market bond funds, and global bond funds.
Venturing into bond funds widens your opportunity in the investment domain, even dating back to some of the oldest balanced mutual funds which feature allocations to both stocks and bonds from the late 1920s.
Advantages of Investing in Bond Funds
Bond funds present a compelling choice over individual bonds due to their ability to offer greater portfolio diversification. By investing in a bond fund, one only pays an annual expense ratio covering marketing, administrative, and professional management fees, avoiding the need to purchase multiple bonds separately and manage individual transaction costs.
Most bond funds invest in a variety of bonds that possess different maturities, thereby minimizing the impact of any single bond’s performance.
Another significant advantage is gaining access to skilled portfolio managers equipped with expertise in researching and analyzing the creditworthiness of bond issuers and market conditions before making investive decisions.
For instance, a fund manager might replace bonds when an issuer faces a credit downgrade or opts to call, or pay off, the bond before it matures.
Important Considerations
Bond funds can be sold any time at their current market net asset value (NAV), resulting in potential capital gains or losses. Conversely, individual bonds might prove tougher to sell.
From a tax perspective, yields on tax-free municipal bond fund investments can result in higher after-tax returns when compared to taxable bond fund investments for investors in higher tax brackets.
Due to the inverse relationship between interest rates and bond prices, long-term bonds carry more interest rate risk than short-term bonds. Accordingly, the NAV of long-term bond funds will be greatly influenced by interest rate changes, affecting the monthly distribution of interest income to participants.
Exploring Bond ETFs
Although bond ETFs have existed for a shorter period than mutual funds, since iShares launched the first bond ETF in 2002, they have grown in popularity. These fund offerings aim to replicate various bond indices, with a rising number of actively managed products available.
ETFs commonly come with lower fees than their mutual fund counterparts and, like stocks, trade throughout the day. Prices for shares can fluctuate within the trading day, leading to noticeable variance.
Bond ETFs function similarly to closed-end funds, as they must be bought through a brokerage rather than directly from a fund company. This logic also applies when selling ETFs: they must be put up for trade in the open market.
Variety in Bond ETFs
Bond ETFs range widely, incorporating investments in entities from California municipal bonds to U.S. and international government and corporate bonds, including several tax-exempt options. They also cover bonds of differing maturities: short, medium, and long-term.
Notable Bond ETFs
As of recent times, the three largest bond ETFs are:
- iShares Core U.S. Aggregate Bond ETF (AGG)
- Vanguard Total Bond Market ETF (BND)
- Vanguard Total International Bond ETF (BNDX)
Top-Performing Bond Mutual Funds
Closing out the first quarter of 2024, among the top-tier funds, notable performers include:
- PIMCO Income International (PIMIX), 8.05%
- American Funds Bond Fund of America (RBFGX), 1.40%
- Dodge & Cox Income X (DOXIX), 4.16%
Concluding Thought
Bond ETFs and bond mutual funds present a viable alternative for investors desiring a consistent income stream without the risk entailed in individual bond-picking.
Typically suited for conservative investors, like all investments, they come with risks—where slightly heightened risks could mean relatively substantial returns.
Related Terms: Stocks, Mutual Funds, ETFs, Interest Rates.
References
- U.S. Securities and Exchange Commission. “Bond Funds and Income Funds”.
- American Economic Association. “What Makes US Government Bonds Safe Assets?”
- Financial Industry Regulatory Authority. “Bonds”.
- iShares. “Bonds Still have a Big Role to Play in Portfolios”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: Exchange-Traded Funds (ETFs)”.
- VettaFi. “Bond ETF List”.
- Morningstar. “How the Largest Bond Funds Did Last Quarter”.
