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Should You Invest In a Bond Fund?

by Laura Adams

For the average investor, buying an individual bond can be intimidating because it takes some amount of expertise to evaluate them. In this article I’ll tell you about a great alternative—investing in a bond fund.

What is a Bond?

Let’s start by making sure you know exactly what a bond is. A bond is a form of debt in which an investor loans money to a corporation or a government entity for a certain period of time at a fixed rate of interest. That’s why bonds are called fixed-income securities. A company might issue bonds to finance a new manufacturing facility overseas or a county might issue bonds to pay for a bridge, for instance.

Bond investors receive a steady stream of income if they hold them to maturity. Bonds are less risky than stocks, but on average they also return less than stocks. Bonds play an important role in each investor’s portfolio because they smooth out volatility and reduce overall risk.

What Is a Bond Fund?

A bond fund is a portfolio of bonds and other debt instruments (like mortgage-backed securities) that are managed professionally. A fund allows you to spread risk across a broad range of individual securities. Some funds are actively managed according to a stated objective and others are designed to mimic an index of bonds and are passively managed.

A bond fund is likely to pay higher returns than certificates of deposit (CDs) and money market investments, but they aren’t completely safe from risk. The return you get on a bond fund can vary dramatically depending on the underlying bonds. For instance, it could be made up of high-yield, risky, junk bonds or it could own low-yield, safe, government securities only. Additionally, all bond funds are subject to interest rate risk. Bonds have an inverse relationship to interest rates—that means when rates rise, the value of a bond fund can go down.

Differences Between a Bond and a Bond Fund

As I mentioned, a bond has a specified maturity date when the term of the investment ends. However, a bond fund does not have a maturity date because bonds are continually added to or removed from the portfolio in response to investor demand and overall market conditions. There are three common types of bond funds: open-end mutual funds, close-end mutual funds, and exchange-traded funds.

What is an Open-End Bond Mutual Fund?

With an open-end bond mutual fund you can buy or sell a share of the fund at any time. But the price of each share is only valued at the end of each trading day. The price is based on the net asset value (NAV) of all the underlying bonds in the portfolio. The value of the fund can be higher or lower than the price of any one bond that’s owned inside the fund.

What is a Closed-End Bond Mutual Fund?

Bonds funds can also be closed-end mutual funds where a limited number of shares are listed and sold. The price of each share fluctuates according to the prices of the securities in the portfolio (and is valued once a day, just like with open-end funds), but there’s also a supply and demand issue that comes into play with the price.

What is an Exchange-Traded Bond Fund?

Unlike either type of mutual fund, exchange-traded funds (ETFs) trade on an exchange, just like stocks. So the price of a bond ETF changes throughout the day as it’s bought and sold. It doesn’t have a net asset value calculated just once a day like a mutual fund does. To learn more about the differences between ETFs and mutual funds be sure to read “ETFs—A Better Way to Invest?

Whether you prefer bond mutual funds or bond exchange-traded funds, they make buying bonds much easier and less intimidating. So don’t miss out on the income and diversification that bond funds can add to your portfolio. To learn more about the right kinds of investments you should make for your situation, be sure to pick up a copy of my award-winning book or e-book Money Girl’s Smart Moves to Grow Rich. You can download 2 book chapters for free at SmartMovesToGrowRich.com.


Published or updated August 29, 2011.
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{ 3 comments… read them below or add one }

1 Derek

The only problem with a bond fund is price risk. When bond prices go down because rates are going up (hasn’t happened for a while), the value of the fund will go down. With an individual bond you know what you will get at maturity. However, like you said, a bond fund doesn’t have a maturity so the value of the fund is solely dependent on the value of the individual bonds inside the fund. So, bond funds may present a problem when interest rates start going up. Nonetheless, I agree that for most people, a bond fund is easier than picking individual bonds. Nice article.

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2 Selling Theta

I’m with Derek on this one. For more advanced investors I would recommend picking individual bonds, other wise a bond fund is the right way to go.

Best,
Selling Theta

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3 Mike L

Yes, a bond fund is easier to invest in. They are also much riskier than most investors realize due to the price risk that Derek points out above. It is gut wrenching to see your portfolio balance decline even as your distribution payouts continue rolling in. I believe bonds should be researched individually and held to maturity to maximize the risk mitigation. An alternative would be to invest in a bond fund when interest rates are decreasing or when the Federal Government provides a backstop ala QE.

I heard Suzy Orman pounding the table about this very topic a few months ago.

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