Irrespective of if you are a novice in investing or a professional money manager, having a good understanding of how bond funds work is very important for investment success as is the case with stock funds. Armed with this knowledge, you can better understand other areas of finance and economics including interest rates, economic indicators, and how they are all interrelated.

So before you learn how bond mutual funds work, you will benefit by learning the basics on how bonds work. A bond is basically a promise to pay and as such it can be likened to a loan. The borrower can be an entity such as a corporation, the U.S. government, or a publicly owned utilities company that issues bonds to raise capital (money) for the purpose of funding projects or to fund the internal and ongoing operations of the entity. The buyers of the bond are the investors that lend money to the entity by buying the bonds, in exchange for periodic payments with interest.

Bonds should not be confused with stock. When you purchase a stock, you are the owner, whereas when you buy bonds you will be the loaner.

For instance, an individual bond pays interest, called a coupon, to the bondholder (investor) at a stated rate for a stated period of time (term). If you hold it to full term and the bond issuer stays faithful, then the bondholders will receive all interest payments and 100 percent of their principal back by the end of the term. In other words, most bond investors do not lose principal; there is no real market risk or risk of losing value, and the interest payments are fixed, which is why bonds are known as fixed-income investments.

It is very important to understand bond risks and relationship between bond prices and interest. The amount of money that will have to be paid by the issuer to the investor of the bond will depend mainly on the term (amount of time to maturity), the credit rating of the issuing entity, and the prevailing interest rates for similar loans at that time. The interest payments (yield) of the bond are generally based upon the risk of default. Therefore, a longer term, such as a 30-year bond, would require a higher interest rate to make the bond payments more attractive to bond buyers wanting to be compensated for the risk of default over such a long period of time.

In the same vein, should an entity issue a lot of bonds, the risk of default will increase. This is the same as a person with a lot of debt being forced to pay higher interest rates on future loans; they are a default risk. The credit rating of the entity issuing the bond reflects the entity’s ability to repay the bond investors. This is similar to a credit score for individuals. Higher credit ratings command lower interest rates, and lower credit ratings justify higher interest rates.

Bond funds can provide important potential benefits in a diversified portfolio some of which include;

  1. They generate income: bonds generate interest payments which can help an investor to build an income stream or reinvest the interest.
  2. Preserve capital: Repayment of the original investment in the bond can help provide reassurance to investors who are concerned about protecting capital or meeting intermediate-term financial needs, such as college tuition or a down payment on a new home. For more immediate financial needs, cash savings, money markets, or other short-term options may be more appropriate. For longer-term goals, investment opportunities with more growth potential may makes more sense.
  3. Manage volatility: Because issuers of bonds generally make interest payments and repay principal, investment-grade bonds can be less volatile than stocks. As a result, bonds can provide the potential for diversification, and help investors interested in lowering their portfolio volatility.

However, it is not without its disadvantages which include;

  1. Fees: Bond funds typically charge a fee, often as a percentage of the total investment amount. This fee is not applicable to individually held bonds.
  2. Variable Dividends: Bond fund dividend payments may not be fixed as with the interest payments of an individually held bond, leading to potential fluctuation of the value of dividend payments.
  3. Variable NAV: The Net Asset Value (NAV) of a bond fund may change over time, unlike an individual bond in which the total issue price will be returned upon maturity (provided the bond issuer does not default).

How Bond Funds Work and How They Differ From Bonds

Bond mutual funds are mutual funds that invest in bonds. Just like other mutual funds, bond mutual funds can be likened to a basket that holds a lot of individual securities. (In this case, bonds). A bond fund manager or team of managers research the fixed income markets for the best bonds based upon the overall objective of the bond mutual fund. The managers then purchase and sell bonds based on economic and market activity. Managers also have to sell funds to meet redemptions (withdrawals) of investors. Because of this reason, bond fund managers rarely hold bonds until maturity.

Just like it was mentioned before, an individual bond will not lose its value so long as the bond issuer does not default (due to bankruptcy, for example) and the bond investor holds the bond until maturity. However, the value of a bond mutual fund can reduce or increase because the fund manager(s) often sell the underlying bonds in the fund prior to maturity. Therefore, bond funds can lose value. This is a fundamental difference between individual bonds and bond mutual funds.

Here’s why: Imagine if you were considering buying an individual bond. If today’s bonds are paying higher interest rates than yesterday’s bonds, you would naturally want to buy today’s higher interest-paying bonds so that you can receive higher returns (higher yield). However, you might consider paying for the lower-interest-paying bonds of yesterday if the issuer was willing to give you a discount (lower price) to purchase the bond. As you might guess, when prevailing interest rates are rising, the prices of older bonds fall because investors demand discounts for the older (and lower) interest payments.

Thanks to this, the price of bonds are known to move in the opposite direction of interest rates, and bond fund prices are sensitive to interest rates. Bond fund managers are constantly buying and selling the underlying bonds held in the fund, so changes in bond prices change the NAV of the fund.

Determining Which Bond Fund Type Is Best for You

The various bond funds have a special purpose for which they were created. In general, conservative investors prefer bond funds that buy bonds with shorter maturities and higher credit quality because they have a lower risk of default and lower interest rate risk. However, the interest received or yield is lower with these bond funds. Conversely, investing in bonds with longer maturities and lower credit quality have greater potential for higher relative returns in exchange for the higher relative risk.

If you are in doubt as to which bond type to go for, then bond index funds can be a smart choice. Above all, considerations in building a portfolio of mutual funds is that you have a diversified mix of mutual funds that are appropriate for your investment objectives and tolerance for risk.

Ajaero Tony Martins