How to Choose the Right Bond Funds
One of the most important aspects of investing in bond funds is understanding the differences in the types of funds and the risks and return characteristics of bonds with different maturities. There are four types of bond funds—bond mutual funds, closed-end bond funds, exchange-traded bond funds and bond unit investment trusts.
They can then be further broken down into three segments based on the bonds' average maturities in the funds’ portfolios.
Learn the differences, risks and returns of each segment of bond fund based on their maturities.
Types of Bond Funds
Bond mutual funds are similar to mutual funds in that they are a basket of selected investment tools that investors can pool their money into. They can be actively or passively managed and can be built to follow bond indexes or other investing strategies.
Bond mutual funds can consist of all of one type of bond with the same maturity dates or a mix of many with different maturities. Managers can add new bonds to the fund or trade out lower-performing bonds to keep the fund in line with the management's strategy.
Open-ended bond funds are the most common types of bond mutual funds that allow you to buy and sell as you see fit within the fund.
Closed-end bond funds have a set number of bonds in the fund. These funds are known to perform well during bond favorable market conditions, but since managers can use leverage (borrow funds from the investors) to purchase the assets, unfavorable market conditions can bring significant losses.
Exchange-traded bond funds trade on the stock markets and can be purchased like stocks through brokerages. Bond unit investment trusts are more typical of what is commonly thought of as bond investing—bonds in a fund are held in a trust to their maturity date. When each bond matures, the fund distributes any proceeds.
Bonds mature in periods referred to as maturities, at which time proceeds are usually paid. Bond maturities typically fall in one of three categories:
- Short-term (less than five years)
- Intermediate-term (five to 10 years)
- Long-term (more than 10 years)
Each of the four types of bond funds can be categorized by the maturities of the bonds within the fund.
Short-Term Bond Funds
Virtually all bonds with maturities of more than a year are subject to the risk of price fluctuations stemming from interest rate risk. The longer the time until maturity, the larger the potential price fluctuations. The shorter the time until maturity, the lower the price fluctuation probability. Short-term bond funds tend to have lower risk and yields.
Also, short-term yields are more affected by the policy of the U.S. Federal Reserve, whereas market forces primarily determine the performance of longer-term bonds. Since investor sentiment changes much more rapidly than Fed policy, this leads to more intense price fluctuations for long-term bonds.
Short-term bond funds are useful for someone who needs liquidity in the near future.
Intermediate-Term Bond Funds
As their name would suggest, intermediate-term bond funds fall roughly in the middle for risk and returns. Intermediate-term bond funds are by far the largest of the three categories.
This is because index funds and funds that tend to invest across the full spectrum of the bond market tend to average out to an “intermediate” maturity. Take care to distinguish between funds that fit this description vs. those dedicated explicitly to intermediate-term bonds.
Long-Term Bond Funds
Longer-term bond funds typically offer higher yields but also greater risk. The risk stems from interest rates, which are affected by inflation. This risk is called interest rate risk. Long-term bonds lock up an investor's money for a longer period than a short-term bond, which leaves more time for interest rate movements and inflation to affect the bond’s price.
Because these results reflected the tail end of a 31-year bull market in bonds, when rates are falling, longer-term bonds will produce higher total returns. Once rates begin to rise, however, this relationship is turned on its head.
Long-term bond funds are excellent if you can withstand the ups and downs of the market and have time to wait for your money.
Bond Performance and Fluctuating Rates
The list below shows an example of how the rate movements affect different maturity rate returns. In March 2017, a rate increase of .25% caused yields on 30-year Treasury notes to fall from 3.14% to 3.02%. A one-day, one-percentage-point increase in prevailing rates could have the following impact on Treasury prices:
- 2-Year: -1.9%
- 5-Year: -4.7%
- 10-Year: -8.5%
- 30-Year: -17.8%
Using a one-day measurement shouldn't infer the proportional movements of bonds of varying maturities over time. However, it does illustrate the higher volatility associated with longer-term bonds.
Determining What’s Best for You
Investors typically adjust their portfolios toward one end or the other based on their risk tolerance, objectives and time frame.
For instance, an investor for whom safety is the top priority would typically sacrifice some yield in exchange for the greater stability and lower risk of loss present in short-term bonds.
On the other hand, an investor with higher risk tolerance and more time until they needed to tap into their principal could take on more risk in exchange for the higher yields available in long-term bonds.
There’s no single right answer as to which approach is the better choice; it all depends on the individual’s situation. However, it’s essential to keep in mind that long-term bond funds aren’t appropriate for someone who needs to use the principal within three years or less due to their higher volatility.