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What Is a Bond Fund?
Let me explain what a bond fund is. It's a mutual fund or an exchange-traded fund (ETF) that buys and sells debt instruments like government and corporate bonds. The main goal here is to generate monthly income for you as an investor.
If you're an investor, think of a bond fund as an alternative to buying individual bonds. You're essentially buying shares in a fund that handles many bonds. The fund manager buys and sells based on market conditions and doesn't usually hold bonds until they mature.
Key Takeaways
A bond fund invests primarily in a portfolio of fixed-income securities such as municipal and corporate bonds. These funds give you diversification with a low minimum investment required. Remember, due to the inverse relationship between interest rates and bond prices, long-term bonds carry more interest rate risk than short-term ones.
Understanding Bond Funds
For many of you, a bond fund is a more efficient way to invest than picking individual bond securities. Unlike those individual bonds, bond funds don't have a maturity date for repaying principal, so your invested amount can go up or down over time.
As an investor in these funds, you'll get monthly payments that reflect the overall mix of bonds in the fund, meaning your interest income will change each month.
What 'AAA' Means
Bonds get rated based on the risk that their issuers might default on debts. An 'AAA' or 'AA' bond comes from a company or government that's highly unlikely to default.
Types of Bond Funds
Most bond funds focus on a specific type of bond, like corporate or government ones. They also target different maturities, such as short-term, intermediate-term, or long-term.
You can choose funds that only buy the highest-quality, safest bonds, like U.S. government bonds or those from blue-chip companies. These high-quality bonds pay lower interest than riskier options.
Note that U.S. government bonds are seen as having the highest credit quality. Funds specializing in U.S. Treasury securities, including Treasury inflation-protected securities (TIPS), are the safest but offer the lowest potential returns.
Riskier Choices
Other funds go for riskier bonds, like high-yield or junk bonds. These offer higher returns but come with a greater chance of the issuer defaulting.
There are also funds that mix different types of bonds to create multi-asset class options. Available types include 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.
Fast Fact
Mutual funds have been investing in bonds for many years. Some of the oldest balanced funds, which allocate to both stocks and bonds, date back to the late 1920s.
Bond Fund Benefits
Bond funds are attractive compared to buying individual bonds because they provide greater portfolio diversification than you could manage on your own.
When you invest in a bond fund, you only pay the annual expense ratio that covers marketing, administrative, and professional management fees. Buying multiple bonds separately would involve transaction costs for each one.
Since a fund invests in many bonds with varying maturities, the impact of any single bond's performance is reduced. Another key benefit is access to professional portfolio managers who research and analyze bond issuers' creditworthiness and market conditions before making moves.
For instance, a manager might replace bonds if the issuer's credit gets downgraded or if the issuer calls the bond early.
Special Considerations
You can sell bond funds at any time for their current market net asset value (NAV), which might result in a capital gain or loss. Individual bonds can be harder to sell.
From a tax angle, if you're in a higher tax bracket, you might get a better after-tax yield from a tax-free municipal bond fund than from a taxable one.
Because of the inverse relationship between interest rates and bond prices, long-term bonds have more interest rate risk than short-term ones. This means the NAV of funds with longer maturities will be heavily affected by rate changes, impacting the monthly interest income distributed to you.
Bond ETFs
Bond ETFs are newer than bond mutual funds, with iShares launching the first one in 2002. Most seek to replicate bond indices, though more actively managed ones are available now.
ETFs often have lower fees than mutual funds. They trade throughout the day like stocks, with prices fluctuating moment by moment and potentially varying a lot during trading.
Bond ETFs work like closed-end funds; you buy them through a brokerage account, not directly from a fund company. When selling, you trade them on the open market—the fund company won't buy them back like with open-ended mutual funds.
Explain Like I'm Five
A bond fund is a mutual fund or ETF that invests in bonds instead of stocks. They can focus on Treasury bonds, municipal bonds, or corporate bonds. Some stick to the safest bonds, while others go for junk bonds with higher returns.
Buying a bond fund lets you get exposure to a large group of bonds without researching each one yourself. Bonds are relatively safe, but their value can drop when interest rates rise.
What Types of Bond ETFs Are There?
There's a wide variety of bond ETFs and mutual funds available. They include those investing in California municipal bonds, U.S. or international government bonds, investment-grade corporate bonds, and tax-exempt bonds. Funds may focus on short-term, medium-term, or long-term bonds.
What Are Some Large Bond ETFs?
Three large bond ETFs are iShares Core U.S. Aggregate Bond ETF (AGG), Vanguard Total Bond Market ETF (BND), and Vanguard Total International Bond ETF (BNDX).
How Can I Invest in a Bond Fund?
To invest in a bond fund, you'll need an online brokerage account, such as at Fidelity, E*Trade, or Charles Schwab. Transfer money into your account so you can purchase the fund. Decide on the type, like a corporate bond fund, government bond fund, or bond index fund. Choose between a mutual fund or ETF, look up the ticker, and buy shares.
The Bottom Line
Bond ETFs and mutual funds are an alternative to picking individual bonds if you're looking for steady income. Like bonds themselves, these funds are generally for conservative investors. As with any investment, taking on a bit more risk can lead to potentially larger returns.
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