What is Bond Fund?
The term “bond fund” refers to the pool of investment that is usually traded in the form of an exchange-traded fund (ETF) or mutual fund. This type of fund typically invests in fixed income securities, such as corporate bonds, government bonds, junk bonds, money market instruments, etc. The basic objective of this type of fund is to generate a steady and stable stream of income for the investors. Bond fund is also popularly known as a debt fund.
From the perspective of investors, a bond fund is a better way of investing in bonds without buying the underlying individual bond securities. The investors are able to generate a steady stream of income by indirectly participating in the interest payment made by the underlying bond securities. Further, a bond fund manager rarely holds any securities until maturity as they usually purchase and sell bond securities in the fund as per the market conditions, and so the bond fund don’t have any maturity date, unlike the underlying individual bonds.
How does Bond Fund Work?
The fund manager pools investors’ funds into a portfolio of fixed income securities, bonds in this case. The investments are usually made in established institutions with high credit ratings. The main focus of such a fund is to optimize the income opportunities while maintaining the risk of credit default (both principal repayment and interest payment) to the minimum.
There are two major sources of income for a bond fund investor –1) capital appreciation due to an increase in the Net Asset Value (NAV) over a period of time and 2) dividend paid by the underlying bonds at certain intervals of time.
Now, let us have a look at some of the best-known bond funds available across the globe:
- Vanguard Total Intl Bd Idx Investor (VTIBX): This fund has a below-average risk rating with an average return profile as per Morningstar. During the last 3 years/5 years as of August 31, 2020, the fund has generated a return of 4.66%/4.27% indicating stable returns across the time period. The expense ratio of the fund is 0.13%, which is below average.
- DFA Five-Year Global Fixed-Income I (DFGBX): This fund has a below-average risk rating with a below-average return profile as per Morningstar. In the last 3years/5 years/10 years as of August 31, 2020, the fund has generated a return of 2.13%/ 2.20%/ 2.25%indicating low but very steady returns across the time period. The expense ratio of the fund is 0.26%, which is relatively higher.
- PIMCO Global Bond Opps (Unhedged) Instl (PIGLX): This fund has an average risk rating with an anabove-average return profile as per Morningstar. In the last 3 years/ 5 years/ 10 years as of August 31, 2020, the fund has generated return of 2.40%/ 3.87%/ 3.09%indicating relatively volatile returns across a time period. The expense ratio of the fund is 0.67%, which is on the higher side.
Types of Bond Fund
Some of the major types have been briefly discussed below:
- Government bond fund: These type of funds invest in the US government backed bonds, suchT-bills, treasury notes, and mortgage-backed securities. The yield on these funds are usually on the lower side as the risk of default risk almost zero.
- Corporate bond fund: These funds are invested in high-quality corporate bonds, which offer higher yield as compared to a government bond fund given the relatively higher risk perception.
- Inflation protected bond fund: These type of funds invest in Treasury Inflation-Protected Securities (TIPS) that are mapped to the prevalent inflation rate in the US, usually Consumer Price Index (CPI) inflation. As the name suggests, these funds help in hedging against inflation.
- Municipal bond fund: These funds are invested in bonds that are issued by the local and state governments. These are good investment options for people in higher income tax brackets as the bonds are free all taxes (local, state, and federal taxes) if issued in the investors’ home state.
- International bond fund: In these type of bond funds the investments are made in bonds issued by foreign governments or corporations. As such, these funds help the investors reduce the interest rate, as well as an economic risk, is given the exposure to various sovereign nations.
- Multisector bond fund: These type of funds invest in a wide range of taxable bonds, such as US Treasuries, high-yield bonds, corporate bonds, etc., and provide the highest degree of diversification to the investors.
Some of the major advantages are as follows:
- Investors are allowed to partake in bond funds much easily as compared to individual bonds.
- The transaction costs are relatively less than what would to be paid for buying the entire set of underlying individual bonds.
- Given that it is a pool of a number of bonds, the impact of a default in any one bond is hardly felt at the portfolio level. This is the benefit of diversification.
- The investors can withdraw or liquidate their investments at any point in time by selling the bond fund at the NAV then.
- These funds are managed by professional fund managers with sufficient experience.
Some of the major disadvantages are as follows:
- The value of these funds fluctuates on the basis of the prevailing interest rates in the market.
- These funds may not always be open to all investors as the fund managers may close the fund to new investors based on certain criteria.
- Unlike the interest payments of the underlying individual bonds, the dividend payments of the bond funds may be variable.
This is a guide to Bond Fund. Here we also discuss the introduction and how does bond fund work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –