When you purchase an individual bond, you normally receive periodic cash interest payments that you are free to spend, save or invest as you see fit. Bond funds work a little differently. Your very first purchase into a bond fund provides you with a piece of a portfolio of bonds, each bond paying interest on its own schedule. Fund managers periodically distribute accumulated interest in the form of dividends. You may be able to reinvest these dividends without fee, but it depends on the fund and your broker.
You can choose between two common vehicles for bond funds: mutual funds and exchange-traded funds. They both are backed by a portfolio of bonds and they both distribute periodic dividends. Although technically classified as “dividends," these distributions are taxed in the same manner as interest, at your marginal tax rate. These dividends do not qualify for any special tax breaks normally afforded to stock dividends. Mutual funds routinely allow you to reinvest dividends without commissions, but ETFs are less consistent.
Exchange-Traded Bond Funds
Bond ETFs start life as initial public offerings (IPOs) of stock. The stock is backed by a basket of bonds that may be tied to a published bond index. Once issued, the ETF stock trades like any other, on a stock exchange. You must pay two different fees to own shares in a bond ETF. First, you pay a brokerage commission to buy the shares. For example, discount brokers might charge around $4 for the purchase of 100 shares, but commissions would vary substantially. Once you own the shares, you pay a management fee to the fund. Bond ETF management fees typically begin around 0.2 percent a year and rise from there.
The distinction between mutual funds and ETFs is important when it comes to dividend reinvestment. If reinvested, bond fund dividends might result in fractional shares. Mutual funds create new shares as needed and routinely deal with fractional shares. ETF shares trade in whole units – you cannot sell a quarter of a share on the stock market. However, many brokers are willing to represent fractional shares in your account, and you earn dividends on these just as you do on whole shares. Some brokers extend this courtesy, while others do not. Your broker may charge a commission for reinvesting ETF dividends, but many do so for free.
Dividend Reinvestment Plans
Many ETF managers offer dividend reinvestment plans when you buy shares from a broker who supplies the shares directly from the ETF management company instead of through a stock exchange transaction. The bond fund dividends are automatically reinvested in your brokerage account, including any fractional shares. Almost all reinvestment plans charge no commission for this service. You must pay taxes on bond fund dividends for the tax year in which they are issued, whether or not you reinvest them, unless you shield the ETF shares inside a retirement account.
- Investor Place: Four Muni Bond ETFs to Buy for the Dividends
- Bond Investing For Dummies; Russell Wild
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.