Many investors are familiar with stock mutual funds. Bond funds are similar: They are pooled investments controlled by a fund manager, who makes the investment decisions. The difference is that the fund contains a mix of bonds rather than stocks. Bond funds offer instant diversification and provide active management for a fee, or provide performance that matches a particular bond index for a much smaller fee. Bond funds can be good investments, but they are not perfect. Luckily, there are strategies to mitigate many bond fund disadvantages.
Interest Rate Risk
Like individual bonds, bond funds react to changes in prevailing interest rates. If interest rates rise, prices of existing bonds must fall to make them competitive with new, higher-interest bonds. Conversely, lower rates boost bond prices. In a bond fund, the manager decides how much interest rate risk to accept, which is a disadvantage if you think you can do a better job with individual bonds. However, many mutual fund families offer floating-rate bond funds, which are fairly immune to interest rate risk since this type of bond adjusts its interest payments to match prevailing rates.
Bond funds have a range of fees that usually depend on their degree of specialization and on the policies of the mutual fund company. A specialized fund that invests in Latin American corporate debt, for example, might be more expensive than a U.S. Treasury bond fund. Funds that very actively manage their portfolios tend to charge higher fees. To save on fees, some investors choose to invest in one or more bond index funds, which are passively managed to match the returns on the associated bond index.
Very few mutual funds accept new investors or redeem withdrawals until after the close of the trading day. Therefore, bond funds are useless to day traders and to investors who like to react quickly to news events. To remedy this disadvantage, investors have shown great interest in bond exchange-traded funds, which are baskets of bonds usually tied to a particular index. You can buy and sell ETF shares anytime the exchange is open.
Barriers to Purchase or Redemption
Some bond funds are hard or expensive to buy. A very popular bond fund may close itself to new investors at the discretion of the fund manager. This is often done when the manager feels that additional bond purchases may dilute the strategy or quality of the portfolio. Other bond funds may favor institutional buyers and set a high initial investment threshold of $100,000 or more. Still others may assess high deferred sales charges on withdrawals that occur in the first year.
- The Complete Guide to Investing in Bonds and Bond Funds: How to Earn High Rates of Returns - Safely; Martha Maeda, James Lyman and Meri Anne Beck-Woods
- All About Bonds, Bond Mutual Funds, and Bond ETFs; Esme Faerber
- Exchange-Traded Funds 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.