Bond Mutual Funds

Overview of Bond Mutual Funds

There are seven primary bond fund categories, five of which are domestic and two international. The domestic categories are: corporate, U.S. Treasury, U.S. agency, diversified municipal and state-specific municipal. The international bond funds can be categorized as developed markets, which are usually referred to as International, and emerging markets. Bond funds that invest in the international developed and emerging markets almost always hold both corporate and government bonds, so I didn't subdivided the international funds to the same degree as the domestic funds. There also are World bond funds, a.k.a. Global bond funds, which are merely aggregations of the domestic and international categories.

The seven primary categories can be further categorized in terms of quality and duration, with yields varying inversely with quality and directly with duration. That is, as the quality increases the yield will decrease because you are accepting less risk, and as duration increases the yield will increase because you are accepting more risk.

Investment-grade bonds of all types offer preservation of capital, a steady stream of income (with the exception of zero coupon bonds) and excellent diversification. TIPS (Treasury Inflation Protected Securities) offer inflation protection, as well.

Bonds rated below investment grade are often referred to as speculative, with good reason. Bond mutual funds that invest in these high-yield bonds do not, or at least should not, claim preservation of capital as an objective. These funds provide a relatively high stream of income to compensate investors for the risks inherent to investing in bonds rated below investment grade. Emerging markets bond funds are usually deemed to be relatively risky and are therefore often classified as low quality, although this is not always a good assumption. Many emerging markets bond funds deserve medium quality status, although risks other than creditworthiness may be a concern, those risks have no bearing on the aggregate quality of the bonds in a fund's portfolio and thus should be considered as a separate issue. Also, many Emerging Markets bonds are unrated, thus they automatically are classified as speculative, just like many domestic municipal bonds that also are not rated.

Among the domestic bond funds, T-Bills provide the best diversification, as they are slightly negatively correlated with the general market. Other government bonds are only slightly correlated with the general market. Although corporate bonds also provide good diversification, their correlation with the general market is somewhat greater than government bonds. Foreign bond mutual funds are good diversifiers, as they are only slightly correlated with the general U.S. stock markets, with emerging markets debt being less correlated than the developed markets.

You will find many domestic bond mutual funds that invest in both Treasury and corporate bonds. This is more prevalent among funds that stick to bonds with high and very high ratings, but some funds that invest in medium grade bonds also add some Treasuries to their portfolio to boost their overall quality rating, although this means sacrificing some yield.

There is one very big difference between bond mutual funds and individual bonds that you need to understand. When you buy a bond and hold it to maturity, you will receive the stated coupon (interest payments) over the life of the bond and you will receive the face value of the bond at maturity, barring a default. Changes in the financial markets, changes in the economy and fluctuating rates of inflation will have no effect on your periodic interest payments and the eventual return of your principal. Although the amount of your principal and interest payments are fixed, the purchasing power of your interest and principal payments will fluctuate with inflation, so bonds held to maturity are not riskless. However, bond funds, although they own bonds, work a bit differently.

Bond mutual funds are constantly trading bonds in an effort to put their expertise to work to earn capital gains and interest that exceed the total return that would be earned by buying and holding individual bonds to maturity. This will usually work in your favor over the long term. Unless you are fortunate enough to buy a bunch of long-term bonds when rates are extraordinarily high, you'll probably do better by owning a bond mutual fund. The downside of this is that the cash flow you receive from the fund will vary and the NAV of your shares will fluctuate, so you won't know the amount you will receive when you redeem your shares until you actually redeem them.

In general, this is good for long-term investors, but if you are approaching a point in time where it is crucial that you know you will receive a fixed amount or a minimum amount from your investment, it's not so good. In that case you should switch from a bond mutual fund into a fixed investment (bond, CD, annuity, etc.) well in advance of your target date to ensure you have that fixed amount locked in.

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Return to the Various Types of Mutual Funds.

Move on to the next subsection, Domestic Bond Mutual Funds.