The first step in choosing a bond fund is to consider your own goals, circumstances and investment personality. Recognize that you will probably have to make trade offs, and that investors often must balance opposing goals like safety and high return.
Fortunately, bond funds come in many varieties, to suit the varied needs of investors. Consider all the kinds of bond funds available before you invest, and the way that they can help you meet your personal goals. First, though, look at some of the steals in the investing world.
A Free Lunch
Whatever type of fund you choose, look for one with a low expense ratio and, ideally, no load. No-load bond funds do exist, and seeking them out will bring investors an automatic increase in yield without a decrease in quality. The Vanguard website is one place to begin looking for no-load bond funds.
Retirement vehicles like Roth and ordinary IRAs and Keogh plans offer a deal for investors too, tax relief in exchange for locking up their money. Many corporations offer matching contributions to pension plans that also amount to free money.
Once you have put your funds in a tax-sheltered vehicle, you are ready to consider the differences in bond funds. One of the most important differences is duration. Bond prices go down when interest rates go up, and up when they go down. Duration is the main factor that governs how much they sink or rise.
Bond Fund Duration
Bond funds may be short, intermediate, or long term. Short-term bond funds contain bonds that will soon mature. Their value does not shoot up or down when interest rates change because they will soon be paid back at face value. A short-term government bond fund might hold bonds that will mature in four years or less. This is a safe investment, though its yield may be relatively low.
At the other end of the spectrum are long-term bond funds. The bonds they hold may not mature for 20 years or more. A lot can happen in that length of time, so the value of these bonds is more volatile. On the other hand, investors receive a higher yield for accepting this risk. Long-term U.S. government bonds are still fairly safe, because the government stands behind them.
In between long-term and short-term bond funds, intermediate maturity bond funds are moderately risky and pay an intermediate yield.
Technically, bond duration is a weighted average of the time to maturity that takes into account the income an investor gets before the bond matures and the bond purchaser is repaid. A zero-coupon bond that matures in seven years has a maturity of seven, because there are no coupon payments to return some capital before seven years pass.
A bond that pays a coupon has its duration shortened, because the investor gets some money back before seven years have passed, and a bond with a large coupon (a high yield) has its duration shortened more. Longer duration means more risk, which means more opportunity for gain or loss. When comparing bond funds, look at duration as one guide to risk.
Various entities issue bonds. Since a bond is really a debt, it matters quite a bit who issues it. The U.S. government is considered a risk-free issuer, because it has the power to tax. As long as people pay taxes, U.S. bonds are likely to be repaid.
Corporations also borrow by issuing bonds. Their debt is considered riskier than government debt, and therefore it usually delivers a higher yield.
Municipal bond interest is untaxed, as a rule, if area residents purchase the bonds. People in high-tax areas can sometimes benefit from buying the appropriate muni bond fund.
Global bond funds contain bonds from around the world. These funds can be difficult to assess, because foreign rules and conditions can be very different from those at home. Fluctuations due to currency movements or unsettled conditions as well as interest rates can affect values.
Corporations, municipalities, and even governments vary in reliability. Therefore, the bonds these entities issue vary in perceived risk. Bond rating agencies rate bonds, and various funds specialize in bonds of various ratings, from investment grade to “junk.”
Junk bonds pay higher yields than investment grade bonds do, but in some circumstances, an investment will shrink more from junk bond downgrades or defaults than it grows from interest payments. It is for the investor to decide whether he or she wants to take the risk of buying junk.
Mutual funds actually come in different types. Open-end funds create shares for you when you buy shares of a fund, and destroy them when you take your money back. The price of your shares fluctuates along with the value of the assets of the mutual fund. This is how most bond funds work, and it works well to diversify assets and spread risk for most investors.
However, there is another kind of mutual fund, the closed-end fund. Closed-end funds issue a limited number of shares, and then only occasionally issue more. The investor buys his shares in this kind of fund on the open market, and sells them the same way. The value of the shares is determined by the market, not by the value of the assets the fund holds.
Therefore, the price of a bond fund share can sometimes fall below the value of the assets it holds. For well-informed and careful investors, this can sometimes result in bond funds selling at a worthwhile discount, and that can result in outsized yields. However, investors must be extremely careful, because many closed-end bond funds are highly leveraged and loaded with derivatives. This may make them far too risky for someone who does not want to think about her investments constantly.
Another way to purchase a variety of bonds is to invest in bond Exchange Traded Funds like AGG, BND, or many others. These ETFs attempt to reproduce the performance of a broad bond index. The investor who buys one of these funds gets diversification, tax efficiency, and the ability to sell the fund at any time the market is open.
To accumulate a sum of money, bond funds that are collections of zero coupon bonds provide an excellent degree of certainty. People might invest in these to prepare for retirement, or as part of a college fund. However, these funds provide no real current income (zero coupon means nothing is paid out), but are taxed as if they do.
For high current income, longer duration and/or lower quality bond funds provide relatively high income, though a balance invested in them is apt to fluctuate much more widely than one in short-term government bond funds.
Municipal bonds provide income that is untaxed for many people, but the yield is often so low that it is essentially equivalent to the after-tax yields on taxable bond funds.
Only you know what you want from your bond fund investment. The more clearly you can visualize your investing goals, the more likely you are to find a fund that precisely suits your needs.