Bond mutual funds offer investors an alternative to traditional stock funds, with a unique set of risks and advantages. Although bond mutual funds function in much the same way as stock funds, there are a number of distinct differences to consider. Understanding bond mutual funds can help you to decide whether this unique investment product is right for your family.
Mutual Funds
Mutual funds gained widespread popularity throughout the twentieth century, and the trend continues through the turn of the century. Mutual funds are a nearly hands-off approach to investing for families who wish to earn a return on their money but do not have the time or desire to get personally involved in investing. Mutual funds pool money from a range of investors into a common fund, which a fund manager uses to make a range of investments. As the fund grows through investment income, the individual account balances of each participant rise according to the proportion of their contribution, and each participant can withdraw money at any time.
Bonds
Bonds are essentially specialized loans from an investor to a corporation or government entity. Corporations can issue bonds in return for quick inflows of capital from investors. Bonds stipulate that the company will pay a certain interest amount to the bondholder each year, then repay the principal amount of the bond at the end of the bond term. Bonds can be held to maturity for annual interest income, or they can be traded to other investors for quick profits.
Advantages
Bond mutual funds that hold bonds to maturity can be much safer than traditional stock mutual funds. Stock values can fluctuate greatly and quickly, but bonds held to maturity generally only go sour when the issuing entity runs into serious financial trouble. Mutual funds that trade bonds for faster returns can be a bit more risky than those that hold bonds until maturity, but they can still be safer than many stock funds.
Disadvantages
In general, investors trade safety for profit potential, or vice-versa. Safer bond mutual funds can yield smaller returns than more aggressive stock funds. Financial advisors often encourage young couples to invest more aggressively than older households, since young people have a longer investment time horizon.
Advice
Take the macroeconomic environment into consideration when deciding whether to invest in bond mutual funds. When the stock market is in turmoil, bond funds can be a safe place to keep your money while earning a reasonable return. In times of economic prosperity, however, the opportunity cost of bond funds compared to stock funds can make bonds less attractive.
