Bonds are very popular securities because they regularly pay interest income and pay back the initial principal after the bond matures. Bonds are popular with people of various risk classes but they certainly appeal to conservative investors looking for a steady income stream. Bond mutual funds may be even more attractive than buying into individual bonds because they provide a portfolio with increased diversification at a low-cost. Needless to say, before considering to purchase into a bond fund consider your risk tolerance, objectives, and income needs and compare that to the goals, risk level, and investment style of the bonds or bond funds you are interested in.
What is a Bond?
A bond is simply a loan between an investor and the bond’s issuer. Say a company issues bonds and an investor can buy those bonds or in other words provide a loan to the company in return for a promise to pay back the initial investment after a specified period along with interest during the intervening period. The interest rate agreed upon by the company and the investor is called the coupon rate. When the bond matures or in other words when it’s time for the company to pay back the loan, the issuer repays the investor’s original investment.
Since bond markets generally don’t move in tandem with equity markets, they can provide investors with the added diversification in their portfolios. Furthermore, they provide investors with a steady income stream. The only exception to this rule is for zero-coupon bonds, which from their name indicate that there are no interests rates attached to these bonds so there is no income paid out over time; however, even though zero-coupon bonds provide no cash flow they are sold at a discount to their face value and at maturity the investor gets paid the full face value of the bond.
There are many kinds of bonds available each having varying risks, benefits, tax implications to an investor’s overall portfolio. Most bonds can be generally organized under four major categories: corporate, government, government agency, and municipal. Corporate bonds are issued by corporations and depending on the corporation that is issued them they can vary in risk. For instance, a small company issuing bonds can offer attractive yields to investors but can at the same time bring with it substantial amount of risk whereas a large-cap company can issue bonds that can be less risky because the investor knows that the chances of the large-cap company to default is slim. On the other hand, government bonds are probably the safest types of bonds because they are issued by the U.S. Treasury and backed by the credit of the U.S. government. Government agency and municipal bonds can vary substantially in risk but they typically fall between corporate bonds and government bonds on the risk spectrum.
Bond Mutual Funds
Many investors want the benefit of diversification to minimize their risk and they generally achieve this end by purchasing a bond mutual fund. This way investors can combine may different bonds into one portfolio and still pursue their fixed income objectives. Because bond funds aim to provide a steady income stream to investors, they are suited to investors that are looking to firstly minimize the impact of equity market fluctuations on their portfolios and secondly to protect their principal and current income. Bond funds may be the most appropriate for investors that are nearing retirement, are in retirement or others who do not easily tolerate fluctuations in the value of their portfolios. However, a bond fund is simply a pooled resource that invests in many bonds, so before investing consider the underlying individual bonds held in the portfolio particularly paying close attention the risk of those individual bonds and how that overall risk may affect the fund and your portfolio.
Risks
All bonds have come level of “credit risk,” which is the risk that the bond issuer will go into default before the bond matures. In that instance, you may lose a portion or all your original principal and any income that may have been due. Bonds are often rated by Moody’s and Standard & Poor’s (S&P) to provide investors on the creditworthiness of the issuer; Aaa or AAA are the highest credit ratings given by these companies. Bond funds also can be issued ratings just like individual bonds based upon the quality of their underlying bond holdings.
Like stocks and other investments, bonds can have other risks from market fluctuations to an investor who is forced to sell them before their maturity date. If an investor is forced to liquidate his bond positions before their time and the bond’s price has fallen at this time, he will lose part of his original investment as well as all future income from the interest. Another risk common to all bonds and bond funds is interest rate risk. Interest rates and bond prices have an inverse relationship, so when interest rates in the economy rise, the bond’s price will generally fall and vice versa.
However, bond holders can avoid running the risk of fluctuating interest rates and market risk if they hold on to their bonds until maturity. On the other hand, bond mutual fund investors should consider these risks more carefully when purchasing into the bond funds they are interested in because fund managers can potentially buy and sell bonds as they see fit to meet the fund’s objectives. As a result, interest rate risks and market risks become more prominent and therefore risk loss because of inherent fluctuations within the bond fund.
Types of Bond Funds
Bond funds also come in many forms each seeking to reach a different purpose and therefore buy and sell individual securities to achieve their goals. Similarly to individual bonds, different bond funds have different risk factors and benefits such as tax benefits. Some popular bond funds include corporate, U.S. government, and municipal bond funds.
Since U.S. government bond funds are composed of securities backed by the creditworthiness of the U.S. government, they hold almost no credit risk. Nevertheless, they are still affected by changes in market conditions, interest rates just like all other bonds, as well as inflation risks – not keeping pace with inflation specifically. U.S. government bonds are taxed at the federal level but are exempt from state level taxes. U.S. government bond funds typically appeal to conservative investors looking for steady income streams and solid protection of their principals.
On the other spectrum, corporate bond funds aim to invest in a variety of corporate issued bonds with different credit risks. Some companies can potentially have substantial credit risks while others have may have less. In addition, corporate bonds are affected by interest rate and market risks. Needless to say, the potentially riskier a bond is can mean that it has potentially higher yields; therefore, these investments may be suitable for investors that can tolerate a bit more risk in pursuit of higher interest income.
Municipal bond funds invest in a variety of bond issues of state government and municipalities. Municipal bonds are taxed at the state and local levels and are exempt from federal taxes. Because of their potential tax benefits, when compared to taxable securities, municipal bonds can be appropriate for investors in high federal tax brackets. Municipal bonds are affected by interest rate and market risks also.
Reduce Risk When Investing in Bonds
1. Try to match your bond maturities to your investment time frame. For instance, if you are retired and you need to withdraw from your portfolio each yeah to meet your day-to-day expenses, buy bonds or bond funds with maturities of one year. In addition, depending on your portfolio you can invest portions of your portfolio in intermediate bonds say 5 to 10 year bonds and long-term bonds (10 years +), for higher interest rate payments.
2. Long-term investors can reduce their risk by buying both short-term and long-term maturity bonds.
3. Buy bonds or bond funds with average maturities that range across the maturity spectrum but with heavier concentration in shorter maturities.
Choose the Fund That Meets Your Need
Although every bond fund carries its own risks, you should always strive to balance the risks with diversification. Diversification can help reduce your overall portfolio risk from any particular fund. Professional management can help you save the hassle from having to research and evaluate the thousands of bonds and bond funds in the market.