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Investing in Bond Funds

Written by Brian Hicks
Posted February 24, 2015

There’s little doubt that bonds belong in your investment portfolio, primarily to provide balance, protection, and — in some cases — tax-free returns on your fixed-income investment.

The numbers back up that sentiment.

According to the Washington, D.C.-based Investment Company Institute, mutual funds comprise $15.86 trillion in total investable assets as of December 2014.

Of that amount, about $3.46 trillion in assets is held in bond funds, one of the most popular and pervasive ways to leverage the benefits of fixed-income investments.

Number of U.S.-based Fixed Income Funds as of December 2014

Category Number
Corporate Bonds 2,088
Municipal Bonds 557
Money Market 528

Total = 7,917

Source: Investment Company Institute

Bond Funds Defined

A bond mutual fund is a professionally managed fund comprised of individual bonds from an accredited investment firm.

In a nutshell, fixed-income investors buy shares in the fund, which can be made up of multiple bond asset classes, including corporate, high-yield, municipal, money market, mortgage-backed, foreign/emerging market, and U.S. Treasury bonds.

Every bond fund share represents a proportional ownership interest in the pool of bonds comprising the fund’s portfolio.

Why Bond Funds?

There is no “best option” for choosing either individual bonds or bond funds for your investment portfolio. In fact, many investors choose to invest in both bonds and bond funds.

Individual bonds offer an investment model where pre-defined payouts come at regular intervals — normally two times annually. That payout is based on the bond’s fixed-rate coupon. When the bond fully matures, its principal is paid out in full to the investor.

There is some inherent risk to investing in individual bonds — most prominently the need to buy and manage fixed-income products while assessing the credit risk of each bond issuer and balancing that assessment against the investor’s own long-term financial goals and cash-liquidity needs.

Cash outlay may be a factor, too. By and large, adequately diversifying your own fixed-income portfolio comprised of individual bonds may require hundreds of thousands of dollars based on the bonds you select and their potential credit risk.

Bond funds, meanwhile, offer some insulation against severe market volatility and don’t require individual investors to manage their own bond portfolios. Key issues like income, risk reduction, and a decreased tax burden are left to professional money managers, who seek to build balanced, diversified funds that take risk largely out of the equation relative to portfolio decisions made by individual investors.

Here are some other advantages of bond fund investing:

  • Current income — Bond mutual funds offer investors a steady flow of current income, giving fixed-income investors a solid balance between cash investments and stock funds. Typically, bond mutual funds offer stronger investment returns than cash investments (like money market funds), with less market volatility (and historically lower returns) than stocks and stock funds.

  • Low “entry” costs — Professional money managers trade bonds in a strategy designed to meet the fund’s investment objective. By pooling investor assets, bond mutual fund investors have access to a wide array of fixed-income investments that are usually out of the reach of average investors. Most bond mutual funds have minimum investments that are significantly less than the principal value of many individual bonds. A case in point — a typical corporate bond may cost $25,000 or more, but a regular investor can invest in most corporate bond mutual funds for as little as $1,000.

  • Simple formula for investors — Bond fund investors can also benefit from the simplified structure of fixed-income funds. For instance, a bond fund’s investment “total return” is made up of three basic components: the fund’s yield, its capital gains distributions, and changes in the value of fund shares. Yield is the most critical component, and it’s defined as a percentage of the maximum offering price per share on a specific date.

Bonds Versus Bond Funds: A Comparison

Solo bonds are managed by you, the investor, come with a set maturity debt, and normally offer a fixed semi-annual income payment, although some bonds pay out monthly or quarterly.

Bond funds, meanwhile, are professionally managed and come with no maturity debt, as bonds are regularly bought and sold within a bond fund. In terms of payout, bond funds provide fluctuating monthly income distribution.

Bond funds can be purchased directly through banks, brokerage and mutual fund firms, and from online banks, brokerages, and mutual fund firms as well.

Key Takeaways with Bond Funds

On the “plus” side:

  • Managed by investment professionals.
  • Low entry price points (of $100 or so) to invest in a bond fund.
  • Easy access to cash via strong bond fund liquidity.

On the “minus” side

  • Investor has to pay management and other fees.
  • Lower returns than stocks and stock funds.
  • Some highly desirable bond funds may be closed off to new investors.

Average Bond Mutual Fund Yields

The PIMCO Total Return Fund (PTTRX) and Vanguard Total Bond Market Index Fund (VBTLX) have returned 5.32% and 4.52% in the past five years.

Both are considered to be industry benchmarks for bond mutual fund performance.

The End Game

Selected correctly, bond mutual funds can provide both capital appreciation and capital preservation to a long-term investment portfolio, hiking return potential while offering good diversification, particularly due to low correlation levels to individual bonds.

With less risk than stocks and the benefits of professional management, bond funds can be an easy way to diversify your portfolio at minimal cost.

Until next time,

Brian O'Connell for Wealth Daily

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