Investing is an important part of saving for the future, but many people are wary of putting their money into the stock market. Stocks can be volatile, with prices that change every day. If you can’t handle the volatility and risk of stocks or want to diversify your portfolio into a less risky investment, bonds are a good way to do so.
As with many types of investments, you can invest in bonds through a mutual fund, which gives you easy diversification and professional portfolio management — for a fee.
Are bond mutual funds a good addition to your portfolio? Here are the basics of these investment vehicles.
What Is a Bond?
A bond is a type of debt security. When organizations such as national and local governments, government agencies, or companies want to borrow money, one of the ways they can get the loan they need is by issuing a bond.
Investors purchase bonds from the organizations issuing them. Typically, bonds come with an interest rate and a maturity. For example, a company might sell bonds with an interest rate of 5% and a maturity of 20 years.
The investor would pay the company $1,000 for a $1,000 bond. Each year, that investor receives an interest payment of $50 (5% of $1,000). After 20 years, the investor receives a final interest payment plus the $1,000 they paid to buy the bond.
What Is a Mutual Fund?
A mutual fund is a way for investors to invest in a diverse portfolio while only having to purchase a single security.
Mutual funds pool money from many investors and use that money to buy bonds, stocks, and other securities. Each investor in the fund effectively owns a portion of the fund’s portfolio, so an investor can buy shares in one mutual fund to get exposure to hundreds of stocks or bonds.
This makes it easy for investors to diversify their portfolios.
Mutual fund managers make sure the fund’s portfolio follows their stated strategy and work towards the fund’s stated goal. Mutual funds charge a fee, called an expense ratio, for their services, which is important for investors to keep in mind when comparing funds.
Types of Bond Mutual Funds
There are many types of bond mutual funds that people can invest in.
Government bond funds invest most of their money into bonds issued by different governments. Most American government bond funds invest primarily in bonds issued by the U.S. Treasury.
U.S. government debt is seen as some of the safest debt available. There is very little chance that the United States will default on its payments. That security can be appealing for investors, but also translates to lower interest rates than other bonds.
Corporate bond funds invest most of their assets into bonds issued by companies.
Just like individuals, businesses receive credit ratings that affect how much interest they have to pay to lenders — in this case, investors looking to buy their bonds. Most corporate bond funds buy “investment-grade” bonds, which include the highest-rated bonds from the most creditworthy companies.
The lower a bond’s credit rating, the higher the interest rate it will pay. However, lower credit ratings also translate to a higher risk of default, so corporate bond funds will hold a mixture of bonds from a variety of companies to help diversify their risks.
Municipal bonds are bonds issued by state and local governments, as well as government agencies.
Like businesses, different municipalities can have different credit ratings, which impacts the interest they must pay to sell their bonds. Municipal bond funds own a mixture of different bonds to help reduce the risk of any one issuer defaulting on its payments.
One unique perk of municipal bonds is that some or all of the interest that investors earn can be tax-free. The tax treatment of the returns depends on the precise holdings of the fund and where the investor lives.
Some mutual fund companies design special municipal bond funds for different states, giving investors from those states an option that provides completely tax-free yields.
The tax advantages municipal bond funds offer can make their effective yields higher than other bond funds that don’t offer tax-free yields. For example, someone in the 24% tax bracket would need to earn just under 4% on a taxable bond fund to get the equivalent return of a tax-free municipal bond fund offering 3%.
High-yield bond funds invest in bonds that offer higher interest rates than other bonds, like municipal bonds and government bonds.
Typically, this means buying bonds from issuers with lower credit ratings than investment-grade bonds. These bonds are sometimes called junk bonds. Their name comes from the fact that they are significantly riskier than other types of bonds, so there’s a higher chance that the issuer defaults and stops making interest payments.
Bond mutual funds diversify by buying bonds from hundreds of different issuers, which can help reduce this risk, but there’s still a good chance that some of the bonds in the fund’s portfolio will go into default, which can drag down the fund’s performance.
Foreign governments and companies need to borrow money just like American companies and governments. There’s nothing stopping Americans from investing in foreign bonds, so there are some mutual funds that focus on buying international bonds.
Each country and company has a credit rating that impacts the interest rate it has to pay. Many stable governments are seen as highly safe, much like the United States, but smaller or less economically developed nations sometimes have lower credit ratings, leading them to pay higher interest rates.
Another factor to keep in mind with international bonds is the currency they’re denominated in.
With American bonds, you buy the bond in dollars and get interest payments in dollars. If you buy a British bond, you might have to convert your dollars to pounds to buy the bond and receive your interest payments in pounds. This adds some currency risk to the equation, which can make investing in international bond funds more complex.
Some bond mutual funds don’t specialize in any single type of bond. Instead, they hold a variety of bonds, foreign and domestic, government and corporate. This lets the fund managers focus on buying high-quality bonds with solid yields instead of restricting themselves to a specific class of bonds.
Why Invest in Bond Mutual Funds?
There are a few reasons for investors to consider investing in bond mutual funds.
Reduce Portfolio Risk and Volatility
One advantage of investing in bonds is that they tend to be much less risky and volatile than stocks.
Investing in stocks or mutual funds that hold stocks is an effective way to grow your investment portfolio. The S&P 500, for example, has averaged returns of almost 10% per year over the past century. However, in some years, the index has moved almost 40% upward or downward.
Over the long term, it’s easier to handle the volatility of stocks, but some people don’t have long-term investing goals. For example, people in retirement are more concerned with producing income and maintaining their spending power.
Putting some of your portfolio into bonds can reduce the impact of volatile stocks on your portfolio. This can be good for more risk-averse investors or those who have shorter time horizons for their investments.
There are some mutual funds, called target-date mutual funds, that hold a mix of stocks and bonds and increase their bond holdings over time, reducing risk as the target date nears.
Bonds make regular interest payments to their holders and the majority of bond funds use some of the money they receive to make payments to their investors. This makes bond mutual funds popular among investors who want to make their investment portfolio a source of passive income.
You can look at different bond mutual funds and their annual yields to get an idea of how much income they’ll provide each year. For example, if a mutual fund offers a yield of 2.5%, investors can expect to receive $250 each year for every $10,000 they invest in the fund.
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Risks of Bond Funds
Before investing in bonds or bond mutual funds, you should consider the risks of investing in bonds.
Interest Rate Risk
One of the primary risks of fixed-income investing — whether you’re investing in bonds or bond funds — is interest rate risk.
Investors can buy and sell most bonds on the open market in addition to buying newly issued bonds directly from the issuing company or government. The market value of a bond will change with market interest rates.
To understand why this happens, consider this example. Say you purchased a BBB-rated corporate bond with an interest rate of 2% for $1,000. Since you bought the bond, market rates have increased, so now BBB-rated companies now have to pay 3% to convince investors to buy their bonds.
If someone can buy a new $1,000 bond paying 3% interest, why would they pay you the same amount for your $1,000 bond paying 2% interest? If you want to sell your bond, you’ll have to sell it at a discount because investors can get a better deal on newly issued bonds.
Of course, the opposite is true if interest rates fall. In the above example, if market rates fell to 1%, you could command a premium for your bond paying 2% because investors can’t find new bonds of the same quality that pay that much anymore.
Interest rate risk applies to bond funds just as it applies to individual bonds. As rates rise, the share price of the fund tends to fall and vice versa.
Generally, the longer the bond’s maturity, the greater the effect a change in market interest rates will have on the bond’s value. Short-term bonds have much less interest rate risk than long-term bonds. Bond funds usually list the average time to maturity of bonds in their portfolio, which can help you assess a fund’s interest rate risk.
Bonds are debt securities, meaning they’re reliant on the bond issuer being able to pay its debts.
Just like people, companies and governments can go bankrupt or default on their loan payments. If this happens, the people who own those bonds won’t get the money they lent back.
Bond mutual funds hold thousands of bonds, but if one of the issuers defaults, some of the fund’s bonds become worthless, reducing the value of the investors’ shares in the fund.
Bonds issued by organizations with higher credit ratings are generally less risky than those with poor credit ratings. For example, most people would consider U.S. government bonds to have a very low credit risk. A junk bond fund would have much more credit risk.
Foreign Exchange Risk
If you’re buying shares in a bond fund that invests in foreign bonds, you should consider foreign exchange risk.
Currencies constantly fluctuate in value. Over the past five years, $1 could buy anywhere between 0.80 and 0.96 euros.
To maximize returns, investors want to buy foreign bonds when the dollar is strong and receive interest payments and return of principal when the dollar is weak.
However, it’s incredibly hard to predict how currencies’ values will change over time, so investors in foreign bonds should consider how changing currency values will affect their returns.
Some bond funds use different strategies to hedge against this risk, using tools like currency futures or buying dollar-denominated bonds from foreign entities.
Mutual funds charge fees, which they commonly express as an expense ratio.
A fund’s expense ratio is the percentage of your invested assets that you pay each year. For example, someone who invests $10,000 in a mutual fund with a 1% expense ratio will pay $100 in fees each year.
Expense ratio fees are included when calculating the fund’s share price each day, so you don’t have to worry about having cash on hand to pay the fee. The fees are taken directly out of the fund’s share price, almost imperceptibly. Still, it’s important to understand the impact fees have on your overall returns.
If you invest $10,000 in a fund that produces an annual return of 5% and has a 0.25% expense ratio, after 20 years you’ll have $25,297.68. If that same fund had an expense ratio of 0.50%, you’d finish the 20 years with $24,117.14 instead.
In this example, a difference of 0.25% in fees would cost you more than $1,000.
If you find two bond funds with similar holdings and strategies, the one with the lower fees tends to be the better choice.
Bond mutual funds are a popular way for investors to get exposure to bonds in their portfolios. Just as there are many different types of stocks, there are many types of bonds, each with advantages and disadvantages.
If you don’t want to pick and choose bonds to invest in, bond funds offer instant diversification and professional management. If you want an even more hands-off investing experience, working with a financial advisor or robo-advisor that handles your entire portfolio may be worth considering.