Whether you are a beginner investor or a professional fund manager, understanding how bond funds work is essential for investment success. Bonds are essentially loans to entities, with promises of interest payments and the return of your principal. Historically, bond yields are affected by interest rates, which in turn are influenced by global and national economic fluctuations.
Basics of Bonds
When you purchase a bond, you become the creditor. The entity that issued the bond is responsible for repaying the amount owed to you, along with periodic interest payments. These payments are not profits but are more like the interest you pay on a loan from the bank. In this case, you are the creditor receiving the interest payments.
For example, an individual bond pays interest, called a “coupon,” to the bondholder (the investor) at a specified rate for a specified period (the term). If held to maturity, and assuming the bond issuer does not default, bondholders will receive all interest payments and 100% of the bond’s principal amount (known as the “face value”) at the end of the specified maturity date.
Note: This means reducing the risk to the investor’s original capital, leading to the term “fixed income.”
Bond Risks, Prices, and Interest Rates
It is also important to understand bond risks and the relationship between bond prices and interest rates. The amount of interest that the issuing entity pays to bond investors primarily depends on the term, the credit rating of the issuing entity, and the prevailing interest rates on similar loans at that time.
Note that some bonds issued in the past were issued at rates lower than the prevailing interest rates today, so their prices are lowered in the secondary market to compensate. Similarly, some bonds were issued at a time when bonds paid higher interest rates than those available today. Those bonds are priced higher in the market to equate price to current yields. Thus, bond prices are affected by changes in prevailing interest rates. By extension, bond portfolios are also “interest rate sensitive.”
Differences Between Bonds and Bond Funds
Mutual funds invest in multiple instruments, using pooled funds from other investors to invest in a variety of securities. Bond funds invest in fixed income securities – these can take the form of U.S. Treasury bonds, municipal bonds, corporate bonds, or bonds from foreign governments and corporations. These entities issue bonds to raise capital (money) to finance projects or fund ongoing internal operations.
Bond mutual funds are mutual funds that invest in bonds. Like other mutual funds, bond funds are baskets containing many individual securities (in this case, bonds).
The bond fund manager or team of managers conducts research on the fixed income bond markets based on the overall goal of the mutual bond fund. Managers buy and sell bonds based on economic and market activity. They also need to sell funds to meet investor redemptions. For this reason, bond fund managers rarely hold bonds until maturity.
Bond Funds Can Lose Value
A bond mutual fund can gain or lose value, as the fund manager(s) often sell the underlying bonds in the fund before maturity. If bond prices have declined since the bond was purchased, the bond loses value at the time of sale.
Note: Because bonds are typically held to maturity, not holding them to maturity and losing value are the fundamental differences between bonds and bond funds.
Bond fund managers buy and sell the underlying bonds held within the fund, so bond prices fluctuate, impacting the overall value of the fund.
Choosing the Best Bond Funds for You
For each
A specific-purpose bond fund determines the type of bonds held in the fund and the type or category of the bond fund. In general, conservative investors prefer bond funds that purchase bonds with shorter maturities and higher credit quality, as they carry lower default risk and lower interest rate risk.
However, the interest received (yield) is lower with these funds. On the other hand, bond funds that invest in bonds with longer maturities and lower credit quality have greater potential for relatively higher returns in exchange for higher relative risk.
Frequently Asked Questions (FAQs)
How do municipal bond funds work?
Mutual funds can have specific concentrations or objectives. One of these concentrations can be in municipal bonds, which come from local and state authorities. They are generally considered riskier than federal bonds, but investors enjoy higher interest rates and tax-free gains at all levels.
Why would someone want to invest in bond funds?
Investors may seek bonds if their goals are to preserve capital and generate income. They may not want to take on risk in volatile investments like stocks. They want guaranteed income in the form of fixed payments.
What are inflation-protected bond funds?
Inflation-protected bond funds invest in Treasury Inflation-Protected Securities (TIPS). These securities promise to adjust their payments to account for movements in interest rates. Bond investors will look for this type of bond fund if they are concerned that interest rates will rise after buying the bonds.
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Source: https://www.thebalancemoney.com/how-bond-funds-work-2466568
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