Takeaways
- Bond funds pool investment capital to invest in predetermined groups of bonds.
- Fixed-income investors invest in funds based on geography, risk level, and term.
- Bond funds provide diversification and reduce single investment risk.
- Bond fund investors spread interest rate and credit risk to a basket of bonds.
- Bond funds invest in different types: corporate, green, agency, international government bonds, and more.
What Is a Bond Fund?
A bond fund is a mutual or exchange-traded fund (ETF) that invests exclusively in bonds. Bonds are debt securities governments, corporations, or other entities issued to raise money. They are securities that pay investors interest, or coupon payments, on the principal amount.
When you invest in a bond fund, you are purchasing exposure to a basket of bonds, which can provide diversification, fixed income, and professional management to your investment portfolio. The two main types of Bond Funds are:
- Bond ETFs: Investors purchase shares in a bond exchange-traded fund, which trade throughout the trading day, like stocks. Bond ETFs can track bond indexes, bond types, or specific credit ratings. Most Bond ETFs are passively managed.
- Bond Mutual Funds: Investors can also purchase shares in a bond mutual fund, which is a pool of capital that invests specifically in bonds. Mutual fund shares trade based on the fund’s Net Asset Value (NAV) at the end of each trading day. Most Bond Mutual Funds are actively managed.
Take the Next Step:
Member FDIC
Quontic High Yield Savings Account
Smart Money Rating: 5/5
APY: 4.50%
Required Minimum Balance: $100
How a Bond Fund Works
Bond funds are actively or passively managed by professional fund managers who invest the fund's capital in various bonds. The specific types of bonds included in a bond fund can vary depending on the fund's investment objectives.
Some bond funds invest in government bonds, while others invest in corporate, green, agency, municipal, or a combination of these bonds. Institutional investors like bonds for their predictability, stability, and income-generating abilities.
Read Also: What Is an Accredited Investor?
How a Bond Fund Generates Income
Bond funds generate income in two ways:
- Interest payments: When you hold a bond, you receive periodic coupons, or interest payments, from the issuer based on the bond's interest rate. The bond interest rate can be fixed or floating. Depending on the bond fund investment policy, interest payments are passed through to bond fund investors or reinvested into more bond purchases.
- Capital gains: Bond funds can also generate capital gains if the bonds' value increases. Bond values can increase if a bond price spikes, or the bond issuer's creditworthiness unexpectedly improves. (Read about how the credit rating agencies rate bonds).
Want to generate regular passive income? Learn How to Build a Bond Ladder
Pros of a Bond Fund
There are several advantages to investing in a bond fund. Here are five pros to consider:
- Diversification: Bond funds can provide diversification because they are baskets of bonds. Investing in many bonds is less risky than single bond risk exposure and can reduce your overall investment risk. (Read more about how to inject investment diversification to your portfolio).
- Professional management: Fund managers with extensive experience investing in bonds manage bond funds. These portfolio managers do the heavy lifting and can free you from the need to constantly research and manage individual bonds. (Read more about active management).
- Liquidity: Bond funds are highly liquid assets, which means you can easily buy and sell shares of the fund. Bond ETFs trade like stocks and are more liquid than Bond Mutual Funds, which only trade at the end of the trading day. (Read about the large stock markets).
- Income generation: Bond funds can provide a steady income stream through interest payments and capital gains. (Read about 9 low-risk investments).
- Tax benefits: In some cases, bond funds can offer tax benefits, such as tax-free interest income. (Read about how to file your taxes).
Take the Next Step: Get Interest Income with a CD
Member NCUA
Consumer Credit Union CD
Smart Money Rating: 5/5
APY: 5.00% on 13 month Certificate (Terms Apply)
Required Minimum: $250
Cons of a Bond Fund
There are always downsides to investing in specific marketable securities. Here are four cons to investing in a bond fund:
- Credit risk: Bond funds are subject to credit risk, which is the risk that the bond issuer will default on its interest or principal payments.
- Interest rate risk: Bond funds are also subject to interest rate risk, which is the risk that the value of the bonds will decline if interest rates rise.
- Expense ratio: Bond funds charge an expense ratio, which is a fee that covers the costs of managing the fund. High fees can erode your overall returns. A bond funds expense ratio is calculated based on its assets under management (AUM).
- Lack of control: When you invest in a bond fund, you do not have control over the individual bonds included in the fund. However, portfolio managers curate the bond fund's holdings over time to optimize yield (otherwise no one would invest in their fund).
Tax Considerations for a Bond Fund
The tax implications of investing in a bond fund can vary depending on the type of fund and your tax situation. In general, interest income from bond funds is taxable as ordinary income. Some bond funds offer tax-free interest income, like those exclusively investing in municipal bonds.
If you sell shares of a bond fund at a profit, you will generally owe capital gains tax on the gain. However, holding the shares for over a year may qualify you for a lower long-term capital gains tax rate.
Learn About: Capital Gains Taxes - Here Are the 2024 Tax Rates
Types of Bond Funds
Bond Mutual Funds or ETFs invest in an array of bonds. They can hone their holding to a particular class of bonds or create a bespoke medley. Here are some types of bond funds:
- Corporate bond funds: These funds invest in bonds issued by corporations. Corporate bonds offer higher returns than government bonds but are also subject to higher credit risk.
- High-yield bond funds: These funds invest in bonds issued by companies considered to be at risk of default. While high-yield bonds offer higher returns, they are also subject to higher credit risk.
- Municipal bond funds: These funds invest in bonds issued by state and local governments. Municipal bonds are often exempt from federal income tax, making them attractive to investors in high tax brackets.[1]
- Government bond funds: These funds invest in bonds, such as debt securities issued by the Treasury Department. Government bonds are generally less risky than corporate bonds, but they also offer lower returns because they are backed by the full faith and credit of the U.S. government.
When researching what type of bond fund to invest in, it is important to consider the fund's expense ratio. The expense ratio is a fee that covers the costs of managing the fund. A high expense ratio can reduce your overall investment returns. You can check the investment policy or research reports on bond funds to compare and calculate their expense ratios.
Where to Invest in Bond Funds
Bond funds can be purchased through your online stock brokerage account. Most online brokerage accounts have a research portal where you can analyze fund returns and historical performance. You can choose to invest in bond mutual funds and Bond ETFs.
Online Stock Brokerage Accounts:
- Acorns
- E*TRADE
- Fidelity
- J.P. Morgan
- Robinhood
Our Picks: Best Online Stock Brokerage Accounts
Take the Next Step:
Acorns Website
Acorns Investing App
Smart Money Rating: 5/5
Intro Offer: $20 Bonus Investment
Best For: Beginner Investors
Annual Fee: N/A
What Are Bond ETFs?
Bond ETFs are bond funds that trade on a stock exchange. Because of this, you can buy and sell shares of a bond ETF throughout the trading day, just like a stock.
Bond ETFs pay their shareholders a monthly interest dividend, which is taxed as ordinary income. The funds also pay an annual capital gains dividend, which is treated as either short-term or long-term capital gains, depending on the length of holding.
It is important to choose the right bond fund for your investment goals. When deciding, you should consider your risk tolerance, investment horizon, and tax situation. Consulting with a financial advisor or robo-advisors can help calibrate how much of your portfolio you should invest in a Bond ETF.
Read Also: 7 High Dividend-Yielding Stocks
Smart Summary
A bond fund is a pool of investor money that invests exclusively in different types of bonds. The two most popular bond fund structures are Bond ETFs and Bond Mutual Funds. Fixed-income investors enjoy investing in bond funds for regular interest payments and capital appreciation. Financial experts agree that bonds should make up a certain percentage of a well-balanced investment portfolio.
You Might Also Like:
(1) U.S. Securities and Exchange Commission. Focus on Municipal Bonds. Last Accessed January 12, 2025.
