Income-oriented investors looking for a diversified portfolio of bonds can select from a huge galaxy of bond mutual funds. There are bond funds for every taste, from ultra-short-term to long-term, composed of bonds issued by the federal government, corporations, state and local governments, or foreign entities. U.S. government bond funds are free from state and local taxes, whereas municipal bond funds may be totally tax-free, depending on where you live. Taxable bond interest is taxed at the investor's marginal tax rate.
Mutual Fund Facts
Mutual funds are professionally managed portfolios that are funded by a pool of investor cash. The goals and constraints of each mutual fund are described in a prospectus, usually available online. Mutual funds charge a management fee and may also charge sales or redemption fees. The fund companies create and cancel shares as needed, and intra-day trading is not available. The net asset value of a mutual fund is the total value of assets, less liabilities, divided by the number of outstanding shares. You purchase and redeem shares at the NAV.
A bond is issued with a face value, often $1,000, and a stated interest rate. If you buy the bond at a discount and hold it until maturity, you will have booked a capital gain on the amount of the discount. The reverse is true for bonds you buy at a premium above face value. Throughout their lives, bond prices fluctuate with prevailing interest rates. Rising rates push down bond prices because older bonds pay less than new ones. Falling rates cause the opposite behavior.
If you buy a bond at its face value, its yield to maturity, or rate of return, will equal its stated interest rate. Discounted bonds have higher yields and premium bonds have lower ones. The current yield of a bond is its annual interest payment divided by its price. From this definition, it is plain that prices and yields must move in opposite directions. As prices rise, yields fall, and vice versa. Short-term bonds are less prone to price and yield changes because they are not far from maturity, at which time their prices will coincide with their face values.
Fund Prices and Yields
The price of a mutual fund share is its NAV. The yield of a bond fund is a weighted average of the individual bond yields within the fund portfolio. The U.S. Securities and Exchange Commission directs bond funds to calculate and publish a “30-day yield,” which is similar to yield to maturity. The “distribution yield” is the monthly payout divided by the NAV. You can choose to have your monthly distribution reinvested in the bond fund, thus compounding your returns. Like individual bonds, bond fund prices fall and yields rise when prevailing interest rates rise.
- The Complete Guide to Investing in Bonds and Bond Funds: How to Earn High Rates of Returns - Safely; Martha Maeda et al.
- The Fundamentals of Municipal Bonds; Neil O'Hara
- Investing for Income: A Bond Mutual Fund Approach to High-Return, Low-Risk Profits; Ralph G. Norton
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.