Smart Bond Investing—Bond Funds

Bond Mutual Funds

 

Mutual funds have become a preferred way to invest for millions of Americans. A mutual fund is simply a pool of money invested for you by an investment firm in a variety of instruments like stocks, bonds or government securities. Each mutual fund is different in its make-up and philosophy.

 

A bond mutual fund is a mutual fund that invests in bonds. Bond mutual funds can contain all of one type of bond (munis, for instance) or a combination of bonds. Each bond fund is managed to achieve a stated investment objective.

 

Like most investments, bond mutual funds charge fees and expenses that are paid by investors. These costs can vary widely from fund to fund or fund class to fund class. Because even small differences in expenses can make a big difference in your return over time, we've developed a fund analyzer to help you compare how sales loads, fees and other mutual fund expenses can impact your return.

 

Types of Bond Mutual Funds

 

Actively Managed Bond Mutual Funds

 

The most common type of bond funds, open-end funds, are actively managed bond funds that allow you to buy or sell your share in the fund whenever you want. You buy and sell at a fund's net asset value (NAV), which is the value or price per individual fund share and is priced at the end of each trading day—not throughout the day, as is the case with stocks.

 

Index Bond Mutual Funds

 

These funds are passively managed and are engineered to match the composition of a bond index, such as the Barclays Capital Aggregate Bond Index. Once the fund is constructed and trading, very little human intervention takes place; the fund's performance is structured to track that of the index it mirrors.

 

Regardless of the type of bond mutual fund you select, keep these points in mind:

 

  1. Return of principal is not guaranteed because of the fluctuation of the fund's NAV due to the ever-changing price of bonds in the fund, and the continual buying and selling of bonds by the fund's manager.
  2. As with direct bond ownership, bond funds have interest rate, inflation and credit risk associated with the underlying bonds owned by the fund.
  3. In contrast to owning individual bonds, there are ongoing fees and expenses associated with owning shares of bond funds.
  4. As with individual bonds, you pay income tax on bond interest according to your tax bracket.

 

Closed-End Bond Funds

 

Like bond mutual funds, closed-end bond funds are actively managed. However, a closed-end fund has a specific number of shares that are listed and traded on a stock exchange or over-the-counter market. Like stocks, shares of closed-end funds are based on their market price as determined by the forces of supply and demand in the marketplace. Shares may trade at a premium (above NAV) or, more often, at a discount (below NAV). Investors should be aware that closed-end funds may be leveraged, meaning the fund has issued or purchased stock or other investments using borrowed funds. While this leverage may result in increased yield during favorable market conditions, it could also result in losses if market conditions become unfavorable. For more information, read our Investor Alert, Closed-End Fund Distributions: Where is the Money Coming From?

 

Exchange-Traded Funds

 

An exchange-traded fund (ETF) is like a mutual fund, but trades on one of the major stock markets and can be bought and sold through a brokerage account throughout the trading day, like a stock. It can track a specific stock or bond index such as the S&P International Corporate Bond Index or be actively managed with a specific strategy in mind. And like stock investing, ETF investing involves principal risk—the chance that you won't get all the money back that you originally invested.

 

Unit Investment Trusts

 

UITs, as they are referred to, are made up of a fixed parcel of bonds that are held in a trust and rarely change once the initial bond purchase is fixed, making it easier to estimate how much you will earn. UITs are passively managed funds. On the trust's maturity date, the portfolio is liquidated and the proceeds are returned to unit holders in proportion to the amount invested. Unit holders who want to sell before maturity may have to accept less than they paid. While UITs are more diversified than an individual bond, they are generally far less diversified than a bond mutual fund. Each bond in the UIT has its own maturity date and often its own call provision as well, which can impact return and should be considered when estimating earnings. As each bond matures, or is called (UITs carry call risk), the principal is paid out to the shareholders until the last bond matures.

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    Bonds Versus Bond Funds