Now that you’re up to speed on treasury bonds, let’s take a look at bond funds and how they work.
What is a bond fund?
A bond fund is a fund invested primarily in bonds and other debt instruments. The exact type of debt in which the fund invests will vary, but investments may include government, corporate and municipal bonds, along with other debt securities. Most bond funds pay out dividends more frequently than individual bonds.
How do bond funds work?
A bond fund represents a collection of securities. The investor pays the mutual fund company an annual fee and sometimes a sales charge (called a load) to buy the fund. In exchange, the mutual fund company offers the investor an instant portfolio with professional management. The interest investors receive from the fund is a portion of the total interest received by all the bonds minus management fees that are taken out.
Most bond funds are open-end funds - meaning that there is no limit for the number of shares available. As more people buy into the fund, more bonds are purchased. The mutual fund shares then sell at a price that directly reflects the price of all the bonds held by the mutual fund.
Most funds are actively managed, which means that the managers try to beat the broad bond market by picking certain issues of bonds or by trying to time the markets. Other mutual funds are passively run, which means they are set up to track standard fixed-income indexes. Index funds tend to cost significantly less in fees than actively managed funds.
Different Types of Bond Funds
Bond funds can be classified by their primary underlying assets
Government: Since a government can always print more money to pay its debt, government bonds are typically the safest. Due to the safety, the yields are typically low.
Municipal: Municipal bonds are issued by state and local governments are subject to certain tax preferences and are typically exempt from federal taxes. In some cases, these bonds are even exempt from state or local taxes.
Corporate: Bonds issued by corporations, whereby the risk depends on the company's ability to pay the loan at maturity. All corporate bonds are guaranteed by the borrowing (issuing) company. Some bond funds specialize in high-yield securities (junk bonds), which are corporate bonds carrying a higher risk. This is due to the potential inability of the issuer to repay the bond. Bond funds specializing in junk bonds pay higher dividends than other bond funds, with the dividend return correlating approximately with the risk.
Bond funds can also be classified by factors such as type of yield or term. They can even be classified by specialty such as international bonds, zero-coupon bonds, convertible bonds, etc.
Advantages of bond funds
Automatic income reinvestment
Disadvantages of bond funds
Variable Net Asset Value (NAV)
There’s a whole lot to learn about bonds, and we really only scratched the surface. If you’re interested in learning more about investing in bond funds, check out our Investing in Different Markets course.