Bonds are among the safest investments out there and bond funds are generally the safest way to invest in bonds. But that doesn't mean you should jump right in with both feet. Here are a few things to consider before you buy.
Know Your Objectives and Know the Fund's Objective
First, ask yourself what you want your bond fund to accomplish. Not all funds serve the same purpose. Are you looking to generate income or are you trying to reduce your tax bills? Maybe you're saving for your child's college education. After you determine your objectives, you can search for a fund that has a similar objective, whether that's maximizing return, protecting principal, or something in between.
Consider Your Tax Status
Tax-free municipal bond funds don't make sense for everyone. Sure, it sounds like a great idea—a fund where you don't pay federal income taxes on what you earn. But unless you're in the right tax bracket, owning municipal bonds or municipal bond funds can be a very bad move. And even if you're in a high enough tax bracket to justify a municipal bond fund, choosing the right one depends on your state of residence.
How Liquid Must Your Fund Be?
When will you need your principal back? You can sell your bond fund shares at any time–unlike with individual bonds–although there's no guarantee that you'll make money on the deal. But as liquid as the bond fund market is, be cautious about locking yourself in for longer than necessary.
If you're working with a short timeframe—maybe you're looking to park some cash for a few weeks or months before using it toward a large expense like buying a home—look no further than a money market fund. But if you have more time to play, you can choose from a wider variety of funds with much longer investment horizons.
Think About the Fees
Nothing will eat away at the gains in your bond fund quite like fees. Never invest in a fund until you understand what its fees are and how they compare with industry averages.
It's worth remembering that there are thousands of no-load funds available. Also, as you'd expect, managed funds—where someone actually makes decisions for you about what bonds to buy and sell—charge higher fees than index funds, which simply duplicate the investments in an index.
Decide If You're Interested in ETFs and UITs
You might want to take a look at two newer forms of fixed-income investments when you're considering a bond fund. Exchange-traded funds (ETFs) are bought and sold on an exchange. Management fees for ETFs are negligible, although you will pay a brokerage fee when you buy or sell.
Unit Investment trusts are also worth a look. A UIT is made up of a collection of bonds, just like a bond mutual fund. But a UIT holds the investments in the trust until maturity. Fees are low compared to mutual funds, but you'll likely pay a brokerage fee. For example, Merrill Lynch's sales charges for UITs in 2021 ranged from 1.85% and 3.5%, depending on the type of UIT.