What Is a Bond Fund? How It Works, Benefits, Taxes, and Types

What Is a Bond Fund?

A bond fund, also referred to as a debt fund, is a pooled investment vehicle that invests primarily in bonds (government, municipal, corporate, convertible) and other debt instruments, such as mortgage-backed securities (MBS). The primary goal of a bond fund is often that of generating monthly income for investors.

Both bond mutual funds and bond exchange traded funds (ETF)  are available to most investors.

Key Takeaways

  • A bond fund invests primarily in a portfolio of fixed-income securities.
  • Bond funds provide instant diversification for investors for a low required minimum investment.
  • Due to the inverse relationship between interest rates and bond prices, a long-term bond has greater interest rate risk than a short-term bond.

Understanding Bond Funds

A bond fund is simply a mutual fund that invests solely in bonds. For many investors, a bond fund is a more efficient way of investing in bonds than buying individual bond securities. Unlike individual bond securities, bond funds do not have a maturity date for the repayment of principal, so the principal amount invested may fluctuate from time to time.

Additionally, investors indirectly participate in the interest paid by the underlying bond securities held in the mutual fund. Interest payments are made monthly and reflect the mix of all the different bonds in the fund, which means that the interest income distribution will vary monthly.

An investor who invests in a bond fund is putting their money into a pool managed by a portfolio manager. Typically, a bond fund manager buys and sells according to market conditions and rarely holds bonds until maturity.

Types of Bond Funds

Most bond funds are comprised of a certain type of bond, such as corporate or government bonds, and are further defined by time period to maturity, such as short-term, intermediate-term, and long-term.

Some bond funds include only the safest of bonds, such as government bonds. Investors should note that U.S. government bonds are considered to be of the highest credit quality and are not subject to ratings. In effect, bond funds that specialize in U.S. Treasury securities, including Treasury inflation-protected securities (TIPS), are the safest but offer the lowest potential return.

Other funds invest in only the riskiest category of bonds—high-yield or junk bonds. Bond funds that invest in more volatile types of bonds tend to offer higher potential returns.

There are also bond funds that have a mix of the different types of bonds in order to create multi-asset class options. For investors interested in bonds, a Morningstar bond style box can be used to sort out the investing options available for bond funds. The types of bond funds available 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.

Mutual funds have been investing in bonds for many years. Some of the oldest balanced funds, which include allocations to both stock and bonds, date back to the late 1920s.

Bond Fund Benefits

Bond funds are attractive investment options as they are usually easier for investors to participate in than purchasing the individual bond instruments that make up the bond portfolio. By investing in a bond fund, an investor need only pay the annual expense ratio that covers marketing, administrative and professional management fees. The alternative is to purchase multiple bonds separately and deal with the transaction costs associated with each of them.

Bond funds provide instant diversification for investors for a low required minimum investment. Since a fund usually has a pool of different bonds of varying maturities, the impact of any single bond’s performance is lessened if that issuer should fail to pay interest or principal.

Another benefit of a bond fund is that it provides access to professional portfolio managers who have the expertise to research and analyze the creditworthiness of bond issuers and market conditions before buying into or selling out of the fund. For example, a fund manager may replace bonds when the issuer's credit is downgraded or when the issuer "calls," or pays off the bond before the maturity date.

Special Considerations

Bond funds can be sold at any time for their current market net asset value (NAV), which may result in a capital gain or loss. Individual bonds can be harder to unload.

From a tax perspective, some investors in higher tax brackets may find that they have a higher after-tax yield from a tax-free municipal bond fund investment instead of a taxable bond fund investment.

Due to the inverse relationship between interest rates and bond prices, a long-term bond carries greater interest rate risk than a short-term bond. Therefore, the NAV of bond funds with longer-term maturities will be impacted greatly by changes in interest rates. This, in turn, will affect how much interest income the fund can distribute to its participants monthly.

Bond ETFs

Bond ETFs have been around for less time than bond mutual funds, with iShares launching the first bond ETF fund in 2002. Most of these offerings seek to replicate various bond indices, although a growing number of actively managed products are also available.

ETFs often have lower fees than their mutual fund counterparts, potentially making them the more attractive choice to some investors, all else being equal. Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of trading.

Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company. Likewise, when an investor wishes to sell, ETFs must be traded on the open market. A buyer must be found because the fund company will not purchase the shares as they would for open-ended mutual funds.

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