How Bond Funds Work

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Whether you are a beginning investor or a professional money manager, understanding how bonds funds work is essential to investing success, as is the case with stock funds. This knowledge can help you understand other areas of finance and economics, such as interest rates, economic indicators, and how they are all interrelated.

The Basics on Bonds

Bond funds invest in bonds. So before you learn how bond mutual funds work, you will benefit by learning the basics on how bonds work. A bond is essentially a promise to pay; it's a loan. The borrower is an entity, such as a corporation, the U.S. government, or a publicly owned utilities company, that issues bonds to raise capital (money) for the purpose of funding projects or to fund the internal and ongoing operations of the entity.

The purchasers of bonds are the investors that lend money to the entity, by ​buying bonds, in exchange for periodic payments with interest. A good way to understand the basics of bonds and how they differ from stocks is that when you buy bonds you're a loaner, and when you buy stocks you're an owner (bonds = loaner, stocks = owner).

Example of How Bonds Work

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 percent of their principal back by the end of the term. In other words, most bond investors do not lose principal; is no real market risk or risk of losing value, and the interest payments are fixed, which is why bonds are called fixed-income investments.

An example of a bond would work something like this: The issuing entity, let's say a corporation such as Ford Motor Company, is offering bonds that pay 7 percent interest for 30 years. The bond investor decides she wants to buy a $10,000 bond. She sends the $10,000 to Ford and receives a bond certificate in return. The bond investor gets 7% per year ($700), usually split into two semiannual payments. After earning 7% per year for 30 years, the investor gets her $10,000 back.

Bond Risks, Bond Prices, and How They Relate to 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 the bond investors depends primarily upon the term (amount of time to maturity), the credit rating of the issuing entity, and the prevailing interest rates for similar loans at that time.

The interest payments (yield) of the bond are generally based upon the risk of default. Therefore, a longer term, such as a 30-year bond, would require a higher interest rate to make the bond payments more attractive to bond buyers wanting to be compensated for the risk of default over such a long period of time.

Similarly, if an entity has already issued large numbers of bonds, the risk of default increases. This is not different than an individual with high levels of existing debt being forced to pay higher interest rates on future loans; they are a default risk. The credit rating of the entity issuing the bond reflects the entity's ability to repay the bond investors. This is similar to a credit score for individuals. Higher credit ratings command lower interest rates, and lower credit ratings justify higher interest rates.

Differences Between Bonds and Bond Funds

Bond mutual funds are mutual funds that invest in bonds. Like other mutual funds, bond mutual funds are like 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 best 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 redemptions (withdrawals) of investors. For this reason, bond fund managers rarely hold bonds until maturity.

As we mentioned before, an individual bond will not lose value as long as the bond issuer does not default (due to bankruptcy, for example) and the bond investor holds the bond until maturity. However, a bond mutual fund can gain or lose value, expressed as net asset value (NAV), because the fund manager(s) often sell the underlying bonds in the fund prior to maturity. Therefore, bond funds can lose value. This is a fundamental difference between individual bonds and bond mutual funds.

Here's why: Imagine if you were considering buying an individual bond (not a mutual fund). If today’s bonds are paying higher interest rates than yesterday’s bonds, you would naturally want to buy today’s higher interest-paying bonds so that you can receive higher returns (higher yield). However, you might consider paying for the lower-interest-paying bonds of yesterday if the issuer was willing to give you a discount (lower price) to purchase the bond.

As you might guess, 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. Bond fund managers are constantly buying and selling the underlying bonds held in the fund, so changes in bond prices change the NAV of the fund.

In summary, a bond mutual fund can lose value if the bond manager sells a significant amount of bonds in a rising interest rate environment because investors in the open market will demand a discount (pay a lower price) on the older bonds that pay lower interest rates.

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, therefore, 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 or 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.

If you're not sure which type of bond fund is best for you, bond index funds can be smart choices. Above all considerations in building a portfolio of mutual funds is that you have a diversified mix of different types of mutual funds that are appropriate for your investment objectives and tolerance for risk.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.