Should You Invest In a Bond Fund? The Pros and Cons of Using Bond Funds in Your Investment Portfolio

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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…

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, closed-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.

This Risks of Investing in Bond Funds

With the stock market largely stalled since May – albeit in record territory – nervousness is developing by investors wondering which direction it will go in from here. That kind of doubt breeds a natural inclination to seek out investment alternatives. One such alternative, traditionally, has been bonds. But since so few people fully understand investing in bonds directly, bond funds are often the vehicle of choice. But bond funds may not be as risk-free as you think.

The Inherent Risks of Holding Bonds

bond funds are not risk-free
Bond funds are not risk-free.

While we often think of a bond as “safe,” they have two inherent risks: default and interest rate risk.

Default is easy enough to understand. If the bond is issued by a corporation or even a local government agency, there’s always the possibility that the issuer may hit on financial difficulties and default on either the interest, the principal, or both.

But you can generally get around this by staying in funds that invest only in the US government securities, which are immune to default since the US government can literally create the money to pay them off.

Interest rate risk is a more complicated one, and the virtual Achilles’ heel of bonds. Simply put, bond prices move in the opposite direction of interest rates. When interest rates fall, bond prices rise – much like stock prices. But when interest rates rise, bond prices fall in order to keep their rates competitive with current levels. This is also true of US government securities, but particularly those with 10 years or more to maturity.

Of course, the way to minimize this risk is by investing in shorter-term securities. For example, 30-year bonds that have 25 years remaining on them, are highly sensitive to changes in interest rates. But a 10 year bond – with three years remaining – will be only minimally sensitive to rate changes, since the ultimate payoff is so close.

If you are looking to invest in bond funds in order to offset the risk of stocks, you want to stay with funds primarily invested in US government securities with maturities less than 10 years. This will eliminate the risk of default, and minimize interest rate risk.

Bond Fund Portfolio Composition

There is another X-factor when investing in bond funds, and that is the actual fund portfolio composition. The bond funds – in an effort to improve fund yield – will invest in a mix of bonds. That can include US government securities, state and local government bonds, corporate bonds, “junk bonds,” and even foreign bonds.

While this may achieve the funds desired goal of increasing yield, it will increase the risk of loss of principal. Other than US government securities, any of the bonds held in the fund could be defaulted on.

One other area to pay particular attention to concerning government bond funds. While a fund can be comprised entirely of government bonds, they may include foreign government bonds. After all – they are government bonds, technically speaking. Among their holdings of US government securities, they may also include higher-yielding instruments from non-US sources that will introduce the risk of fluctuating currency values.

I think it’s safe to say that when investing in bond funds, most people are looking for preservation of capital. As you can see, however, not all bond funds necessarily deliver on this expectation.

Your best protection is to get a copy of the fund’s prospectus before investing any money. Find out specifically what their investment holdings are – and makes sure they match your investment goals. Also, pay close attention to their historic performance. Significant declines in investment value over the past 10 years can be an indication that it’s not the fund for you, especially since interest rates have behaved so reliably over that time period.

Stocks and Bonds Aren’t so Mutually Exclusive

The key to solid portfolio management is maintaining a mix of mutually exclusive investments. But if you are looking for diversification away from stocks, bonds – especially long-term bonds – may not be so mutually exclusive.

Historically, both stocks and bonds have risen in price on lower interest rates. They’ve also tended to decline in tandem during periods of rising interest rates. While bonds react to changes in interest rates on a mechanical basis – because it intimately affects yield – stocks react because changes in interest rates affect corporate borrowing and the general direction of the economy. The similar reaction to interest rate changes puts both stocks and bonds too close to achieve true diversification.

Should You Add a Bond Fund to Your Investment Portfolio?

Bonds are a natural diversification away from stocks, but are bonds a good investment choice right now? And after decades of strong bond performance, could we even be on the edge of a bond bubble?

It all hinges on interest rates. Since bonds move in an inverse direction to interest rates – when rates rise, bond prices fall, and when interest rates fall, bond prices rise – the fate of bonds rests entirely upon the direction of rates.

The Case for Using Bond Funds In Your Investment Portfolio

Bonds can prove to be a solid investment this year under at least four different scenarios.

1. Interest rates could stay low for several more years.

Though the economy is growing, it is doing so at a relatively slow rate. There is little incentive for the Federal Reserve to advocate for higher interest rates at this point, and that can mean several more years of low rates. That being the case, 30-year US Treasury bonds paying in excess of 3% per year are a whole lot better than short-term savings instruments that are paying well below 1%.

2. Interest rates could go even lower, raising bond prices.

Though interest rates are at historic lows, that doesn’t mean that they can’t go even lower. The economy is growing slow enough that it could drop into negative territory, and if it does, there will be tremendous pressure to lower interest rates even further. Should rates drop, not only will a 3% 30-year bond rate be highly desirable, but the price of those bonds can also increase as a result, leaving the holder of the bond with a substantial capital gain – in addition to the higher than the market rate.

3. Bonds could be safer than stocks in a market fall.

It’s possible that the stock market could decline even though the overall economy stays in a modest growth phase and interest rates remain level. From a standpoint of safety of principal, bonds could become the preferred investment as a place to earn relatively high interest rates without any risk of principal.

4. International instability.

Still another development that could prove to be an advantage for bonds could be international instability causing a flight to the safety of US investments in general, and of bonds in particular. Such a development could cause interest rates in the US to decline (and bond prices to rise) as a result of a flood of foreign money looking for safe haven investments. Bonds would be a natural destination for that capital, turning this into one of the best-performing years ever for the asset class.

The Case for a Bond Bubble Burst

All of the above outcomes notwithstanding, it’s hard to argue in favor of bonds given that they are at such extreme levels. Logic – and the law of changing circumstances – almost dictate that a shift (a bond bubble) is coming. Will it happen soon? And if it does, what are some possible scenarios?

1. Bonds can’t compete with returns on stocks.

Let’s say that interest rates don’t rise – that should make bonds a solid investment for the rest of the year, shouldn’t it? Maybe not. If stocks turn in another strong year – and let’s say that they earn 10% for the year – you will lose about 7% on your money for every dollar invested in bonds and not in stocks. Stocks and bonds compete with one another, and with interest rates as low as they are it isn’t hard for stocks to win the competition. This could lead to a gradual exodus out of bonds and into stocks, forcing interest rates higher and accelerating the problem.

2. Historic low rates are bad for bonds.

Interest rates on bonds are at historic lows, and that should always make an argument in favor of caution. It’s also the strongest argument in favor of a bond bubble. Sooner or later, rates will turn up and then . . . .

3. Interest rates could rise, crushing bond prices.

The nuclear scenario for bonds would be a reversal of an over 30-year trend of steadily declining interest rates. Should the market begin demanding 4% or 5% on long bonds, the bond market, in general, will take a bath. This can tie your money up in a very long-term security that could leave you holding an investment with sub-par interest rates and no way to get out without losing money.

4. 30-year bonds aren’t much different from stocks.

In rising interest rate market environments, bonds can prove to be no safer than stocks. While it’s true that you will recover your entire principal balance if the bond is held to maturity, the market value of that bond can fall substantially before that happens. If you are in year number three of a 30-year bond, the security can behave very much like a stock and fluctuate wildly. The story of low interest rates makes this more than a remote possibility for bonds in the current market.

The Safer Alternatives to a Bond Fund

If you’re looking for safety of principal as a diversification away from stocks, short-term US government bond funds will be the preferred alternative. But perhaps even better is holding short-term US government securities direct. You can do this through the US Treasury’s investment portal Treasury Direct, where you can buy any type of Treasury securities in any denomination and for any term you choose.

You can also buy Treasury securities through your bank or brokerage firm, although there will be a nominal cost to do so. Alternatively, you can also invest in certificates of deposit or even money market funds. Each will provide safety of principal, along with regular interest income, and represent a complete diversification away from the risks of a portfolio invested 100% in stocks.

Have you ever invested money in a bond fund only to find out that it was not quite as safe as you expected?

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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  1. Derek says

    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.

  2. Selling Theta says

    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

  3. Mike L says

    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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