Bond Funds Explained

What is a Bond Fund?

Income funds or bond funds are terms used to describe a particular type of investment company—primarily mutual funds, unit investment trusts, or closed-funds—that invest solely in bonds or other types of debt-laden securities.

Depending on the company’s investment policy and objective, a bond fund may concentrate its strategy in a particular type of debt or bond security. For example, bond funds may allocate the majority of their capital towards the investment of municipal bonds, corporate bonds, mortgage-backed securities, government bonds, zero-coupon bonds, or fixed-rate bonds. Additionally, bond funds may develop a portfolio to combine or mix any of the aforementioned debt securities.

The types of debt securities that bond funds will possess will vary in regards to the risk, duration, return, volatility, and other features associated with the debt securities.

What is the risk Associated with investing in a Bond Fund?

An individual who invests in a bond fund is susceptible to obtaining a loss of their investment. A typical misconception among many investors is that fixed-income securities or debt securities such as bonds and bond funds possess little to no risk. Similar to any investment, bond funds are subject to a number of investment risks including, interest rate risks, credit risks, and prepayment risks.

A bond fund’s prospectus will disclose the aforementioned risks and all other risks associated with the fund’s investment strategy. Before investing in any bond fund, an individual or entity should carefully review and read all of the available information, including the prospectus and the most recent shareholder report issued by the bond fund.

Credit Risk: The risk that the issuers of the bonds owned in a bond fund’s portfolio may default—meaning the bonds fail to pay the debt they owe on the bonds that have already been issued. The credit risk may be minimal for funds that primarily invest in U.S. Government bonds.

Interest Rate Risk: The risk that the market value of the bonds owned by a bond fund will fluctuate as interest rates rise and fall. For example, when interest rates rise, the market value of bonds owned by bond funds will generally decrease. Typically, all bond funds are subject to this type of risk, but bond funds holding bonds with longer maturities are subject to this form of risk than funds that hold bonds with shorter maturities. As a result of this type of risk an individual can lose money in a bond fund, including those individuals who invest only in government bonds or insured bonds.

Prepayment Risk: Risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates decline. As a result of interest rates declining, the fund may reinvest the proceeds in bonds with lower interest rates, which can reduce the fund’s overall return.

Tax advantages Associated with Municipal Funds?

Bond funds who invest in municipal bonds pay interest which is exempt from federal income taxes. Furthermore, interest obtained on the bonds of some states is exempt from taxation by that particular state. Not all of the income received from a municipal bond fund; however, will be exempt from federal or state income tax. The particular fund’s prospectus will elucidate upon any tax-exempt features.

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