For many investors‚ and even for those with years of experience‚ selecting the right bonds for your portfolio can feel like a daunting task. If that sounds like you, bond funds could be the answer.

Before we can understand bond funds, though, we must first understand the assets that comprise them.

What are bonds? 

Bonds are investment vehicles that essentially provide loans to their issuers. So when you buy a bond, you’re basically lending money to the organization selling the bond. They’re commonly used by governments and corporations to fund various projects (infrastructure, research and development, etc).

At the time of the bond maturity (assuming you continue to hold the bond and the company doesn’t default), the organization is responsible for paying back the entire principal (the amount you paid for the bond in the first place). In addition, like any standard loan, as a lender you’re entitled to collect interest throughout the period that you hold the bond. Interest payments on bonds are referred to as coupons.

An interesting feature of bonds is that their market price tends to move in the opposite direction of interest rates. So as interest rates lower, the market value of a bond increases.

Let’s look at why…

Say you purchased a bond from Company ABC at a 5% coupon rate, with a 30-year maturity. That means, assuming you hold the bond for its full lifespan, you’re entitled to collect 5% interest on the bond for 30 years.

Imagine then that five years into the bond holding, interest rates are slashed to zero due to some unforeseen economic event (say, a global pandemic).

Suddenly, new bond yields are a lot less attractive. Investors might be inclined to pay a greater amount for a bond with a higher yield, even if the maturity is shorter. 

On the other hand, in high-rate environments, it becomes much more difficult to dump your bond holdings. Why buy a bond from a private seller that’s paying 2% interest, when you could buy a new bond directly from the issuer that’s paying a 7% yield?

It’s important to note that, while bond interest rates are tied to Fed rates, they’re not the same thing. A bond’s coupon rate is also tied to the quality of the company issuing it, and its maturity date. Low credit ratings and long maturity dates substantially increase investor risk, so you’re usually compensated with higher coupon rates.

Investing in bond funds

Bond funds are exactly what they sound like: mutual funds and exchange-traded funds (ETFs) that invest in bonds. And depending on your specific investor profile, they may present a more attractive alternative than selecting individual bonds.

Like all funds, bond funds represent a pool of assets – in this case, bonds across an array of coupon rates and maturity dates. And like all funds, there are bond funds for a range of investment goals and interests:

  •     Investment-grade: High-quality funds focused on safe, steady returns.
  •     High-yield: Riskier bonds, but with a focus on greater rewards.
  •     Municipal: Focuses specifically on small government (municipal) bonds. These are known to be a low-risk way to collect steady income.
  •     Multisector: Funds that invest in a variety of bonds across a range of industries.
  •     International: A focus on foreign as well as domestic government bonds.

Each of these bond types comes with its own set of pros and cons, but there are also general benefits to bond funds as an asset class:

The minimum required investment is low to nonexistent, investing in funds provides immediate diversification without having to research each individual asset and the portfolio manager is doing all the legwork, finding bonds to buy and deciding which to sell before maturity. What’s more, bond funds tend to be more liquid than individual bonds. You can sell them at any time for their net asset value (NAV) and you’ll collect consistent monthly income based collectively on the coupon rates of the fund’s holdings. 

However, there are also some drawbacks to investing in bond funds rather than individual bonds.

  • Rate risk: Because the value of bonds tends to move in the opposite direction of interest rates‚ rising rates could cause your fund to lose value. It’s important to note that “rate risk” is compounded by a bond’s given maturity. Longer maturities represent riskier investments, so if a fund is focused on bonds with longer lifespans, its NAV is more likely to be reactive to interest rate movements.
  • Credit risk: If the fund is focused on lower-quality bonds or risky bonds (like high-yield), there’s a greater chance that an asset will default. (This isn’t a huge risk with high-quality bond funds.)
  • Bond funds can lose value depending on the decisions of the portfolio manager.
  • You can lose your principal investment. Because bond funds are based on their NAV, any drop in the NAV could cause a loss.
  • Prepayment risk: If an issuer decides to pay off its debt early, that could impact your total yield.

Choosing a bond fund

As with any investment strategy, the right bond fund for you will depend on your investment goals, time horizon, and risk tolerance.

For instance, if you’re looking for safe, steady (if unexciting) returns, investment-grade bond funds with shorter maturities could meet your needs, since they’re at less risk from rate changes. On the other hand, if you prefer to take on more risk for a greater potential reward, you might prefer to invest in high-yield bond funds, or funds focused on longer maturities.

Whatever your goals, Magnifi makes it easy to search for and find the right mutual funds and ETFs to meet your bond investing needs. Learn more and get started today at Magnifi.com.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Try it for yourself today.

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