Bond funds can diversify your portfolio, but it’s important to understand how they compare to other investments. Like stocks or exchange-traded funds, Like any other investment, bond funds have both pros and cons. They can be a low-cost option with consistent returns, but they also come with some risk. Here are some key things to keep in mind before investing in these funds.
What Are Bond Funds?
Some bond funds may focus solely on short-term investments. Others are designed for the buy and hold investor. Certain funds may attempt to track a specific market benchmark or index.
Some bond funds are actually exchange-traded funds (ETFs), rather than traditional mutual funds. ETFs trade on an exchange, just like a stock. Compared to regular mutual funds, bond ETFs may have a lower turnover rate. That causing them to be more tax-efficient. ETFs also tend to carry lower management fees.Types of Bond Funds
Bond funds aren’t all alike. There are several broad categories of bond fund investments, including:1. Investment-grade bonds
This includes bonds that have been classified as investment grade by bond rating organizations. These are high-quality bonds and may include Treasury bonds, mortgage-backed securities, corporate bonds and inflation-protected bonds.2. High-yield bonds
The overall goal of high-yield bond funds is to generate income and consistent returns for investors. While these types of bond funds may offer more reward than investment-grade bonds, they also tend to carry more risk.3. Municipal bonds
Municipal bond funds focus solely on municipal or muni bonds. These are bonds linked to local and state government agencies. When a government entity issues a municipal bond, it allows them to raise funds (using the money you invest in the bond) to pay for public projects like bridges or buildings. The chief advantage of municipal bonds is that they can create reliable income without the higher risk profile of high-yield bonds.4. Multisector funds
Multisector bond funds can include a mix of different bond types, with varying risk and reward profiles. For example, you might find high-, low- and intermediate-quality bonds in this type of fund. You might also have a mix or high-yield and municipal bonds.5. International funds
The bond fund types outlined so far focus primarily on U.S. or domestic bonds. With an international bond fund, you get exposure to foreign bonds as well as those issued by U.S. organizations and companies.Upside of Bond Fund Investing
There are several good reasons to include bond funds as part of your overall investment strategy. According to Mark Charnet, founder and CEO of American Prosperity Group in Pompton Plains, New Jersey, the top advantages of bond funds are:
Bond funds are a good way to diversify your portfolio, beyond just holding stocks.
In terms of risk, bonds are comparatively less risky than stocks or mutual funds. While you may not earn a double-digit return with a bond fund the way you might with a stock or ETF, the returns you earn from bonds tend to be more consistent and predictable. That’s important if you’re interested in generating some stable income within your portfolio.Downside of bond fund investing
One of the biggest drawbacks associated with bond funds is interest rate risk. Generally, when interest rates rise the value of fund shares can diminish. That can reduce returns. Bonds with a longer horizon until maturity are typically more vulnerable to changing interest rates than short-term bond funds.
Credit risk can also be an issue with bonds and bond funds. Bond funds that include more lower-quality holdings tend to carry more credit risk (meaning more risk of default) than high-quality bond funds.How to Choose Bond Funds
Selecting bond funds isn’t that different from choosing any other investment. It begins with determining your goals, risk tolerance and time horizon, as well as the current interest rate environment.
For instance, if rates are rising, you might be more interested in short-term bond funds. Or, if you have decades to go before you retire, the higher return potential of high-yield bonds might be attractive.
When evaluating individual bonds and bond funds, consider focusing on the fundamentals. The bond or fund’s share price, its 30-day yield, and its total return over time are key to its performance. Also pay attention to the types of bonds in your fund and the fund’s credit risk.
Next, decide what percentage of your portfolio should include bonds and bond funds. For example, a 60/40 portfolio is a 60% to 40% split between stocks and bonds. Using the rule of 110, however, you’d subtract your current age from 110 to get the percentages you should allocate to stocks and bonds. So, if you’re 30 years old, the rule of 110 would dictate putting 80% of your portfolio in stocks and the rest in bonds.Remember Taxes
Gains from bond funds, like those of any other investment, may be subject to tax. If you’re holding them in your 401(k) or a traditional IRA, taxation would be deferred until you begin making qualified withdrawals. With a Roth IRA, your withdrawals are always tax-free as long as they’re qualified.
But if you hold bond funds in a taxable brokerage account, you’d be subject to capital gains tax if the fund distributes dividend income or capital gains. You’ll also be taxed if you sell the fund at a profit. This typically doesn’t apply to municipal bonds, which are usually tax-exempt.Bottom Line
Investing in bond funds doesn’t have to be complicated;. If you understand how bonds and bond funds work, as well as where they fit in your broader portfolio, they could be a sensible investment.
Bond funds can help to offset some of the volatility associated with stock investing while helping you generate income for the short- or long-term.Tips for Building a Portfolio
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