Bonds are debt instruments issued by a government or a corporation to raise money. When you purchase a bond, you are loaning money to the issuer. Bond funds are mutual funds that invest in bonds.
Bonds can be a part of an individual investment plan, providing potentially higher yields than cash investments, like savings accounts, but with potentially less risk than with equities (stocks). A bond mutual fund is different from buying individual bonds, in that the fund buys a variety of bonds, thus providing a more diversified investment. Professional management of the portfolio is another advantage of a bond fund.
All bonds are not created alike! As with any other investment, there is a general correlation between risk and income, although there is more to it than that. The maturity dates of bonds can make them short-, medium-, or long-term investments. Some bonds even provide tax-free income!
Tax-free bond funds typically offer lower yields than taxable funds, but the difference in taxable income can often provide a reasonable offset. Municipal bond funds are exempt from federal taxes, and some are even exempt from state and local taxes. Many state-issued bonds are exempt from income tax (federal, state, and local), while some state bonds are not tax-exempt. The difference is something the manager of a tax-free bond fund has to understand so the individual investor does not.
A bond’s credit rating is the assessment of the risk of an issuer not repaying the bond and interest on time. A rating of AAA is the highest, with a rating of C being one likely to default. The interest rates paid correlate to the risk, with AAA bonds paying the least, and C-rated bonds paying the highest rates (if you can collect!).
There is a market for C bonds, because not all of them are from poorly capitalized or defaulting companies. Bonds from emerging markets are likely to have low ratings, simply because there is no history against which to measure credit worthiness. They may be good investments, but the rating shows the inherent risk in investing in the unknown.
Credit risk is not the only risk involved with investing in bonds, certificates of deposit, and other investments that are designed to produce income. There is a rate risk involved. With a long-term investment, like a twenty year bond, you are tied into a rate of return for a loooooong time. If interest rates remain stable, or decline, so good. If interest rates are rising, then you are stuck with something that could easily be generating more income elsewhere.
This sort of risk can be minimized by investing in a bond fund, because of the diversification of investments by the fund. Even in a long-term U.S. Treasury fund, the fund manager buys securities on a regular basis, rather than the one-shot deal that a private bond investor might make. Although the portfolio’s value fluctuates, this rolling of investment dollars keeps out much of the volatility of the yield of this type of portfolio.
Bond funds come in a wide variety of flavors, ranging from very safe investments, such as government bonds, that may be long- or short-term securities, to those that primarily invest in “junk” bonds, gambling the stability of principal against the higher yields. There are international bond funds, corporate bond funds, and blended bond funds, which invest in a variety of bonds.
A stock broker can help you invest in a bond fund, just as with a mutual fund. To skip those brokerage fees, you may want to directly contact an investment management firm such as T. Rowe Price, Vanguard or Fidelity. Other options may be to include a bond fund in your asset allocation, if you are allowed, in your 401(k) or deferred compensation plan.
When you go to the web site of an investment firm, look at the different funds they offer. If you want to seriously look at investing in a bond fund, you have a few questions to ask yourself first:
1) What do I want to achieve? Do I want something producing regular, stable interest payments over the long haul?
2) What is my risk tolerance? Am I willing to chance losing some of my investment to potentially make more income?
3) How does a bond fund fit into my overall investment strategy? Am I looking to reduce my risk by diversifying my stock portfolio with a bond fund? Am I looking for something to produce more income than my bank accounts, as long as it is relatively safe?
When you decide what you want and why, then you can review the bond fund offerings. Note that there is usually a minimum investment of $1500 or more, so do not expect to invest in a mutual fund with a hundred bucks and twenty a month after that. The initial investment also varies from fund to fund, so that is one more piece of your homework.
Then go to a finance site, such as Yahoo Finance (http://finance.yahoo.com/), where you can check and compare the historical performance of various funds. Mutual funds have symbols much like publicly traded stocks, and can be checked the same way. Once you have done your homework, you are ready to decide where to invest your money.