A bond mutual fund, also known as a bond fund or a debt fund, works exactly how it sounds—it is invested predominantly in bonds or other debt. Bond mutual funds may invest in a variety of debt types, ranging from government and corporate debt to debt securities. Before investing in this kind of fund, it’s important to understand both the benefits and risks that come with investing in them and what bonds actually are. Discover everything you need to know on how to start investing in bond mutual funds.
In order to understand bond mutual funds, you must first understand the underlying asset in which they invest in. A bond is a promise from an entity that money will be paid. The borrowing entity can be anything from a publicly owned company to the U.S. government.
Entities use bonds to raise money. When you purchase one, you are loaning an entity money in exchange for periodic payments and interest. The bond is for a stated amount and for a stated period of time. If you hold the bond until it matures (the end of the agreed upon time period), you will make 100% of your money back, plus all interest. Since the only way you’re unable to make your money back is for the entity to default, bonds are referred to as fixed income.
Bond Prices and Interest Rates
Another key aspect to be aware of is the relationship between bond prices and interest rates. The interest rate relates to the risk of the entity defaulting. That means if there’s a higher risk of an entity defaulting, the borrowing entity must pay more in interest. Many factors affect interest rates, but the two primary factors include the following:
- Term of Bond. This is the bond’s length of time, also known as “the time to maturity.” A longer-term bond is typically riskier since there is an extended time for the borrowing entity to default.
- Credit Rating. A credit rating is the entity’s ability to repay the bond investors. Private independent credit rating companies determine this, which is described as a letter grade. A lower credit rating means the chance of default is higher, which will lead to a higher interest rate.
Understanding Bond Mutual Funds
A bond mutual fund is run by a portfolio manager. The portfolio manager trades bonds based on market conditions—not the maturity of the bond—so they often aren’t held until maturity. This means that the value of the bond mutual fund, which is known as the Net Asset Value (NAV), may fluctuate. In addition, a bond mutual fund typically specializes in a specific type of debt and time frame. The time frames for bond mutual funds are either short-term, intermediate-term, or long-term.
Benefits of Bond Funds
There are plenty of benefits of investing in bond mutual funds:
- Efficiency. One of the major appeals of investing in bond mutual funds is that it allows you to invest more efficiently by diversifying your investment.
- Decreased fees. Bond funds also have the potential to decrease fees. This is because the annual expense ratio usually covers management fees, administrative fees, etc. Plus, they are often preferable to buying individual bonds, where transaction costs can quickly add up.
- Easier to sell. Bond funds are usually easier to sell than individual bonds.
Risks of Bond Funds
Be aware that bond funds can actually lose value. Though you may earn more from investing in a mutual fund, you also have a higher chance of losing your principal investment than you would when investing in individual bonds. Note that all investment involves risk, and no investment is ever guaranteed.
Types of Bond Funds
There are a few major types of bond mutual funds, which are based on different types of debt:
- Investment grade. These come from U.S. Treasury, certain U.S. corporations, U.S. Government agencies, or bonds backed by other assets.
- Municipal. Also known as “muni” bonds, these are issued by states or local governments. Typically, these bonds come with the advantage of being tax exempt (though you still pay capital gains tax).
- High Yield. These funds invest in securities with lower credit quality. They come with more risk and volatility.
- Multisector. As the name implies, these funds invest in bonds in many different sectors. This offers the potential for increased diversification.
- International and Global. These are taxable bonds issued by foreign governments and companies. However, it can also include U.S. based bonds.
Speak With a Financial Advisor
It can be difficult to learn how to start investing in bond mutual funds on your own. They all have different objectives, so the right one for you may depend on your tolerance for risk, overall financial goals, and other investments. To learn more about bond mutual funds, speak with a financial advisor from Good Life Financial today!