A bond fund
is a collective investment scheme
that invests in bonds
and other debt securities. Bond funds yield monthly dividends
that include interest payments on the fund's underlying securities plus any capital appreciation in the prices of the portfolio's bonds. Bond funds tend to pay higher dividends than CDs
and money market
accounts, and they generally pay out dividends more frequently and regularly than individual bonds.
Bond funds can be classified by their primary source:
- Government/Treasury: Composed primarily of treasury securities, which are the safest debt securities, as they are backed by the full faith and credit of the United States government. Due to the safety, the yields are typically low.
- Mortgage: Mortgage loans issued or guaranteed by government agencies such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie Mac), and Federal National Mortgage Association (Fannie Mae).
- Corporate: Bonds issued by corporations. All corporate bonds are guaranteed by the borrowing (issuing) company, and the risk depends on the company's ability to pay the loan at maturity. Some bond funds specialize in junk bonds, which are corporate bonds carrying a higher risk, due to the potential inability of the issuer to repay the bond. Bond funds specializing in junk bonds – also known as "below investment-grade bonds" – pay higher dividends than other bond funds, with the dividend return correlating approximately with the risk.
- Municipal: Tax-sheltered bonds issued by state and local governments and agencies. They are exempt from federal taxes, and in some cases, even states or local taxes.
Bond funds may also be classified by factors such as type of yield (high income) or term (short, medium, long) or some other speciality such as zero-coupon bonds, international bonds, multisector bonds or convertible bonds.
Advantages over individual bonds
- Management: Fund managers provide dedicated management and save the individual investor from researching issuer creditworthiness, maturity, price, face value, coupon rate, yield, and countless other factors that affect bond investing.
- Diversification: Bond funds invest in many individual bonds, so that even a relatively small investment is diversified—and when an underperforming bond is just one of many bonds in a fund, its negative impact on an investor's overall portfolio is lessened.
- Automatic income reinvestment: In a fund, income from all bonds can be reinvested automatically and consistently added to the value of the fund.
- Liquidity: You can sell shares in a bond fund at any time without regard to bond maturities.
Price charts on bond funds typically do not reflect their performance due to the lack of yield consideration. To accurately evaluate a bond fund's performance, both the share price and yield must be considered. The combination of these two indicators is known as the Total Return.