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Bond Index Funds: The Pros and Cons

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bond index funds

Bond index funds invest in a selection of bonds intended to reflect the performance of a particular index. They can provide investors with a window to diversified, low-fee investing. However, bond index funds also carry several risks. We’ll explore the pros and cons of investing in bond index funds. Of course, a financial advisor can also guide you through selecting the bond index funds that are right for you.

Bond Index Funds: A Breakdown

A bond index fund is a diversified portfolio of bonds that are chosen to align with the performance of a specific bond index. The Barclays Aggregate U.S. Bond Index is commonly used, as it covers most U.S.-traded bonds and some foreign bonds. In a nutshell, an index seeks to track the value or performance of the securities in that index. So a bond index fund invests in those securities with the aim of closely matching that performance.

Bond index funds come in many forms, including bond mutual funds and exchange-traded funds (ETFs) that invest in bonds.

Pros of Investing in Bond Index Funds

You can easily invest in bond index funds through an investment firm. Or, you can buy shares of a bond ETF through an online brokerage. Below, we’ll explore some of the potential advantages of investing in bond index funds.

Diversification: Some bond index funds aim to match the performance of broader indices, like those investing in the broader bond market. Rather than investing in a particular sector, these bond index funds aim to reflect the value of the entire bond market. Indices that track one particular sector of the bond market may underperform in the event that sector undergoes some kind of downturn.

Low Fees: Bond index investing is a form of passive investing. Rather than seeking to outperform the bond market, bond index funds aim to mimic it. Hence, the term “passive.” A smaller degree of management and operating costs goes into running these funds on the side of the managers. Those savings can be passed on to investors in the form of lower fees. The opposite may be true for actively managed funds. In this case, fund managers carefully select securities with an aim to beat the index. That takes a lot of management, which could mean higher fees. These fees can take a major chunk out of your return in a low-yield interest rate environment.

Payments: Most bond funds pay interest on a monthly basis as opposed to individual bonds, which tend to do this on a semi-annual basis.

Cons of Investing in Bond Index Funds

bond index funds

Any investment comes with risks. Bond index funds are no different. Below, we’ll explore some of the drawbacks you should watch out for.

Volatility: Most broad-based bond index funds invest in government securities, including those from the U.S. government. This means they are highly sensitive to fluctuations in the interest rate environment.

Performance: Most investors consider bonds as generally safe investments, even though there will always be risk involved. But safer investments also tend to generate smaller returns in the long term.

Time horizon: When you invest in individual bonds, your risk tends to decrease the longer you hold it and the closer you get to maturity. That’s not necessarily the case with bond funds. Because they are portfolios of different bonds, the issues constantly mature and get bought or sold.

Are Bond Index Funds Right for Me? 

To determine if bond index fund investing is right for you, it’s important to understand the difference between the benefits of bond index funds and those of individual bonds. Bonds typically pay an interest rate or coupon payment twice a year. And if you sell it at maturity, you get the principal back as well.

However, bond funds are composed of various bonds. Each may have a different point of maturity and fund managers can buy and sell these at will. Bond funds typically make monthly payments, which you can then reinvest. Plus, they may climb along with interest rates. However, you won’t know when and if you’re getting your principal back.

Nonetheless, some fund managers try to increase their funds’ income payments when interest rates rise by buying newer bonds with the higher coupon rates. In addition, you can reinvest your monthly income payments to buy new shares.

One way you can aim to take advantage of the pros and minimize the cons of index bond investing is through diversification. Based on your risk tolerance, you may also consider investing in growth-oriented securities, like equities, rather than focusing solely on bonds. These can include stock index funds, which historically have outperformed most actively managed funds in the long term. So if you have a long time horizon and a high risk tolerance, you may find it better to invest more heavily in equities and less so in bond index funds.

The Takeaway

bond index funds

Investing in bond index funds can be one way to increase your exposure to safer, low-fee securities. But you may also encounter some hidden risks. Bond funds that invest heavily in government-backed securities, for example, may be highly volatile in a high interest rate environment. You may benefit from diversifying your investments to include exposure to other types of securities, such as stock funds. Always pay attention to your risk tolerance and time horizon when building your portfolio and determining your asset allocation.

Investing Tips
  • If you’re not sure how to divvy up your investments, use our asset allocation calculator. It can help you visualize what a diversified portfolio may look like based on varying risk tolerance levels.
  • Investing in bond index funds can be risky. Working with a financial advisor can help you ensure that you’re making the right decisions for your financial life. You can use SmartAsset’s financial advisor matching tool to find advisors in your area. The tool also provides you with access to the advisors’ profiles, so you can review their qualifications and areas of specialty before deciding to work with one.

Photo credit: iStock.com/monsitj, iStock.com/SusanneB iStock.com/MF3d

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