What Are Bond Funds? | The Motley Fool (2024)

A bond fund is an investment vehicle that pools capital from multiple investors to buy a portfolio of bonds or other debt instruments. Bond funds are often a more efficient way for individual investors to gain exposure to the asset class than buying individual securities, with the added value of better diversification.

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There are many different considerations when investing in bond funds, from the type of bond fund to choose, to the pros and cons of buying bond funds versus buying individual bonds. You’ll also need to understand how to compare the performance of bond funds. This article will cover everything you need to know.

Understanding bond funds

Understanding bond funds

A bond fund is similar to a stock mutual fund. Instead of buying stocks, however, the fund manager buys bonds or other debt instruments to meet the fund’s objective.

Fund managers will rarely hold bonds until maturity. Instead, they’ll buy and sell bonds more frequently to maintain maturities within the bounds outlined by the bond fund. If a bond fund aims to invest in government Treasury bonds maturing in seven to 10 years, the manager will sell bonds maturing sooner to maintain an average maturity in the portfolio between seven and 10 years.

Bond funds pay out interest to their shareholders. Payments are typically made monthly, but they can fluctuate from month to month based on the bonds in the fund portfolio.

To pay for the fund manager and other operating costs of the bond fund, investors have to pay some fees. Most bond funds charge an expense ratio, a fee based on the amount of assets invested with the fund. Some will charge a sales fee or redemption fee paid at the time of purchase or sale, respectively. Some charge a flat annual fee.

Types

Types of bond funds

There are bond funds for just about any type of bond you might want. Types range from the safest government bonds to the riskiest junk bonds, which offer relatively high yields.

Here are the main types of bond funds you’ll find:

  • U.S. Treasury funds: These funds come in short-, medium-, and long-term styles. Short-term funds are usually classified as holding Treasuries that mature in one to five years, medium-term funds mature in five to 10 years, and long-term funds hold government bonds maturing in more than 10 years. Treasury funds may also invest in Treasury Inflation-Protected Securities, or TIPS.
  • Municipal bond funds: Some funds invest in municipal bonds, also called munis. One special characteristic of municipal bonds is that the interest is exempt from federal tax. On top of that, many states also exempt the interest paid by bonds sold by municipalities in that state. So you might buy a municipal bond fund that only invests in munis from your state.
  • Corporate bond funds: Many companies issue bonds as an alternative to selling stock to fund their growth. Corporate bond funds will invest in those bonds. Some may stick to corporations with a threshold credit rating. A higher credit rating comes with a lower interest rate, but the risk of losing principal is less. Some bond funds specialize in junk bonds, or bonds issued by corporations with low credit ratings. These have higher coupon rates, but they also come with more risk.
  • Emerging market funds: Emerging market bond funds invest in bonds issued by governments and government-owned entities in emerging markets.
  • Global funds: Global funds invest in bonds issued by governments and government-owned entities in developed markets outside of the United States. Both global funds and emerging market funds can provide geographic diversification for investors.
  • Mortgage-backed securities funds: A mortgage-backed security, or MBS, is created by packaging illiquid mortgages into a single security. These securities are supported by the mortgages behind them and are packaged based on the credit attached to the individual loans. They can offer better interest rates than government bonds with more safety than corporate bonds since most people will do a whole lot before they default on their home mortgage.

You can also invest in a multi-asset class fund, which will invest across various types of bonds. This can be useful for gaining general exposure to the bond market at a low cost.

Pros and cons

Pros and cons of bond funds

ProsCons
You can invest in lots of different bonds at once to spread out your risk.Management fees and sales fees.
Bond funds are typically easier to buy and sell than individual bonds.Less predictable future market value.
Monthly income.No control over capital gains and cost basis.
Low minimum investment.
Automatically reinvest interest payments.

Measuring performance

Measuring bond fund performance

There are several important performance measurements for bond fund investors to keep in mind when comparing various funds and assessing their portfolio.

First, there’s the net asset value, or NAV. Net asset value is the value of the entire portfolio of bonds divided by the number of shares of the mutual fund. This is what determines the price of a bond fund. Ideally, the NAV for your funds increases over time.

But bonds also pay out interest on a regular basis, so you’ll also want to consider the yield of a bond fund. Most funds display the 30-day annualized yield for their portfolio, which is the average yield of all bonds it holds over the past 30 days. That yield may increase or decrease based on the market.

Importantly, some bonds’ interest payments are exempt from federal taxation and others are exempt from state taxes; some may be exempt from both. As such, you may want to calculate the tax-equivalent yield, which considers the required yield if the taxable gains were equivalent to the tax-free yield. This will vary depending on the investor’s state and income.

Putting it all together, you can calculate the total return of a bond fund. Total return considers interest payments and changes in NAV over a set period. This is the best measure of bond fund performance, especially since they’re often used for income generation and not capital appreciation.

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The bottom line on bond funds

Investors looking to add bonds to diversify their portfolio will do well with a bond fund. Not only is buying a bond fund easier than buying a portfolio of individual bonds, but it’s often less expensive when you factor in the commissions and costs associated with buying individual securities. The ability to buy a bond fund and keep your assets there without having to reinvest once your bonds reach maturity also makes it the simplest route to bond investing for most individuals.

FAQs

Bond Fund FAQs

What’s the difference between bonds and bond funds?

A bond is an individual security backed by a single entity such as a government or company. When you buy a bond, you’re lending money to the issuer at a fixed interest rate described by the bond. Therefore, you’re locking in an interest rate and hoping a single entity won’t default. A bond fund pools investor money to buy a large diversified group of bonds, often from multiple entities, reducing risk.

How are bond ETFs different from bond funds?

A bond ETF typically seeks to track a certain index by buying bonds with the same characteristics as those tracked by the index. A bond fund may be actively managed, with a manager seeking the best bonds available within the fund’s mandated criteria. An ETF, or exchange-traded fund, is traded on an exchange, similar to a stock. Shares trade hands throughout the trading day, and every seller needs a buyer. Conversely, bond funds trade hands at the end of the trading day after determining the NAV. The mutual fund company will issue or retire shares as needed, so liquidity isn’t a concern for individual investors.

What does fixed income investment mean?

A fixed income investment is a financial instrument or security that pays a fixed rate until maturity. Bonds are an example of a fixed income investment because the coupon rate on an individual bond never changes regardless of other economic factors like inflation.

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What Are Bond Funds? | The Motley Fool (2024)

FAQs

What Are Bond Funds? | The Motley Fool? ›

Bond funds offer efficient diversification, allowing investors to spread risk across multiple bonds, enhancing portfolio stability. Types of bond funds range from safer options like U.S. Treasury to riskier ones like junk bonds, catering to various risk appetites.

What bond does Motley Fool recommend? ›

Top 8 Bonds to Invest In for the Long Term
NameTickerYield
10-Year Treasury Note(ICE:^TNX)4.2%
I Savings BondsN/A5.3%
iShares TIPS Bond ETF(NYSEMKT:TIP)5.7%
Nuveen High-Yield Municipal Bond Fund(NASDAQ:NHRMX)5.0%
4 more rows

What funds does the Motley Fool recommend? ›

Two compelling thematic funds
Fund1-year return (%)5-year return (%)
Stonehage Fleming Global Best Ideas18.176.0
Royal London Sustainable Leaders Trust9.757.8
Sanlam Global Artificial Intelligence37.6162.7
Schroders Global Healthcare1.163.4
1 more row
Dec 26, 2023

Will bond funds recover in 2024? ›

Positive Signals for Future Returns

At the beginning of 2024, bond yields, the rate of return they generate for investors, were near post-financial crisis highs1—and for fixed-income, yields have historically served as a good proxy for future returns.

What is a bond fund in simple terms? ›

What is a bond fund? "Bond funds" and "income funds" are terms used to describe a type of investment company (mutual fund, ETF, closed-end fund or unit investment trust (UIT)) that invests primarily in bonds or other types of debt securities.

What is the rule of 72 Motley Fool? ›

Let's say that you start with the time frame in mind, hoping an investment will double in value over the next 10 years. Applying the Rule of 72, you simply divide 72 by 10. This says the investment will need to go up 7.2% annually to double in 10 years. You could also start with your expected rate of return in mind.

Does Warren Buffett recommend bonds? ›

Berkshire takes a “barbell” approach of using stocks and cash because Buffett isn't enamored of bonds—and hasn't been for a decade or more—even with the rise in yields since 2022.

What 10 stocks did Motley Fool recommend? ›

See the 10 stocks »

The Motley Fool has positions in and recommends Alphabet, Amazon, Chewy, Fiverr International, Fortinet, Nvidia, PayPal, Salesforce, and Uber Technologies. The Motley Fool recommends the following options: short June 2024 $67.50 calls on PayPal. The Motley Fool has a disclosure policy.

What does The Motley Fool recommend? ›

The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Vanguard Index Funds-Vanguard Growth ETF. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft.

What is Motley Fool's all in buy? ›

We regularly see similar ads from the Motley Fool about “all in” buy alerts, sometimes also called “double down” or “five star” buys, and they're generally just the type of steady teaser pitch that they can send out all year, over and over with no updates, to recruit subscribers for their flagship Motley Fool Stock ...

Is now a good time for bond funds? ›

Fed rate policy's impact on your investing

So what's the significance of tight Fed policy for your investments? Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income.

Why are bond funds performing poorly? ›

The share prices of exchange-traded funds (ETFs) that invest in bonds typically go lower when interest rates rise. When market interest rates rise, the fixed rate paid by existing bonds becomes less attractive, sinking these bonds' prices.

Should I hold onto bond funds? ›

Traditionally, the answer has been that bonds provide diversification and income. They zig when stocks zag, providing income for spending needs. In finance terms, bonds have “low correlation” levels to stocks, and adding them to a portfolio would help to reduce the overall portfolio risk.

What are the cons of bond funds? ›

The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.

What happens to bond funds when interest rates fall? ›

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

How do you make money off of a bond fund? ›

Bond funds allow you to buy or sell your fund shares each day. In addition, bond funds allow you to automatically reinvest income dividends and to make additional investments at any time. Most bond funds pay regular monthly income, although the amount may vary with market conditions.

What is the best bond to buy in 2024? ›

The Vanguard High-Yield Corporate Fund (VWEHX) takes the top spot on our list of the best high-yield bond funds for June 2024 thanks, largely, to its low expense ratio.

Which bond gives the highest return? ›

Invest in safer portfolio without compromising returns.
Bond nameRating
13.66% ICL FINCORP LIMITED INE01CY07RJ5 SecuredBRICKWORK BB+
9.73% BANK OF BARODA INE028A08059 UnsecuredCRISIL AAA
14.25% KAAR TECHNOLOGIES INDIA PRIVATE LIMITED INE175X07011 SecuredUnrated
9.75% MUTHOOT FINCORP LIMITED INE549K08293 UnsecuredCRISIL AA-
16 more rows

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