Whether you are a beginning investor or a professional money manager, understanding how bond funds work is essential to investing success. Bonds are essentially loans to entities, with promises of interest payments and the return of your capital. Historically, bond yields are affected by interest rates, which are in turn affected by global and national economic swings.
Bond funds were created to allow investors to pool their money into accounts that were invested in bonds and managed by a professional in the hopes of generating more returns. If you are considering investing in bond funds, it is important to understand both how bonds function, and how a bond fund works.
The Basics on Bonds
When you purchase a bond, you become the lender. The entity that issued the bond takes responsibility for paying you back, with periodic interest payments. These payments are not dividends but are more similar to the interest you pay on a loan from a bank. In this case, you are the lender and are receiving the interest payments.
For example, an individual bond pays interest, called a coupon, to the bondholder (investor) at a stated rate for a stated period of time (term). If held to maturity, and the bond issuer does not default, bondholders will receive all interest payments and 100% of their principal back by the end of the term.
This amounts to reduced risk on an investor's principal and gives rise to the term "fixed income."
A bond issuance works similar to this simplified example: The issuing entity, such as Ford Motor Company, is offering bonds that pay 7% interest for 30 years (this is known as the coupon rate, and the time period is known as the term to maturity). The bond investor decides they want to buy a $10,000 bond. They give $10,000 to Ford and receive a bond certificate in return.
The bond investor receives 7% per year ($700), usually split into two semiannual payments. After earning 7% per year for 30 years, the investor gets their $10,000 back; this amount is commonly known as the yield to maturity—the total amount received from the coupon payments and the original $10,000. It is this value that bond investors are most interested in.
Bond Risks, Prices, and Interest Rates
It's also essential to understand bond risks and the relationship between bond prices and interest rates. The amount of interest paid by the issuing entity to bond investors depends primarily upon the term, the credit rating of the issuing entity, and the prevailing interest rates for similar loans at that time.
Bond Interest Rates
Market interest rates and bond interest rates are different. Bond interest rates are the interest payment, or the yield, of the bond. They are generally based upon the risk of default. Therefore, a bond with a longer-term, such as 30-years, would require a higher interest rate—because longer terms are more risky—to make the bond payments more attractive to bond buyers wanting to be compensated for the risk of default.
Similarly, if an entity has issued large numbers of bonds, the risk of default increases—the company is increasing the amount of debt it keeps. This is similar to an individual with high levels of existing debt being forced to pay higher interest rates on future loans; they are a default risk.
Entities that issue bonds are subject to credit ratings, just as individuals are.
The credit rating of the entity issuing the bond reflects their ability to repay bond investors. Higher credit ratings command lower interest rates, and lower credit ratings justify higher interest rates.
Bonds have a par value (face value). When you purchase a bond, depending upon prevailing interest rates, you can end up paying either more or less than the par value. Prices are also affected by market interest rates.
The past performance of bonds during recessions indicates that as interest rates go down, bond prices go up. However, as bond prices go up, their yields go down (if purchased at the higher price). These relationships lead investors to look for other methods to create a profit on investments or hedge the inherent risks in their portfolios.
The prevailing interest rate is the current average interest rate of a market in an economy.
When prevailing interest rates are rising, the prices of older bonds fall because investors demand discounts for the older (and lower) interest payments. For this reason, bond prices move in the opposite direction of interest rates, and bond fund prices are sensitive to interest rates.
Differences Between Bonds and Bond Funds
Mutual funds invest in multiple instruments, with money pooled from other investors to invest across a spectrum of securities. Bond funds invest in fixed securities—these can take the form of U.S. Treasuries, municipal bonds, corporate bonds, or foreign government and corporate bonds. These entities issue bonds to raise capital (money) for the purpose of funding projects or to fund internal and ongoing operations.
Bond mutual funds are mutual funds that invest in bonds. Like other mutual funds, bond funds are baskets that hold dozens or hundreds of individual securities (in this case, bonds).
A bond fund manager or team of managers research the fixed income markets for the bonds based upon the overall objective of the bond mutual fund. The managers then purchase and sell bonds based on economic and market activity. Managers also have to sell funds to meet investor redemptions (withdrawals). For this reason, bond fund managers rarely hold bonds until maturity.
Bond Funds Can Lose Value
A bond mutual fund can gain or lose value because the fund manager(s) often sell the underlying bonds in the fund prior to maturity. If bond prices have fallen since the bond was purchased, the bond loses value at the time of sale.
Since bonds are usually held until maturity, not holding to maturity and losing value are fundamental differences between bonds and bond funds.
Bond fund managers are constantly buying and selling the underlying bonds held in the fund, so changes in bond prices change the overall value of the fund.
Choosing the Best Bond Funds for You
Each bond fund has a certain objective that dictates the type of bonds held in the fund and the bond fund type or category. In general, conservative investors prefer bond funds that buy bonds with shorter maturities and higher credit quality because they have a lower risk of default and lower interest rate risk.
However, the interest received (yield) is lower with these bond funds. Conversely, bond funds investing in bonds with longer maturities and lower credit quality have greater potential for higher relative returns in exchange for the higher relative risk.