Choosing the bond fund that's right for you depends on many factors. What's your investment goal? Are you looking for income from your investments, or are you a long-term investor who's looking to build a diversified portfolio? You must also decide whether you want to hold your bond funds in an individual retirement account (IRA), a 401(k), or in a regular brokerage account.
Ask yourself these basic questions before you choose the best bond funds for your goals.
- Bond funds pass interest payments, less fund expenses, to investors.
- The 30-Day SEC Yield reflects the dividends and interest earned during the period, after expenses.
- You can also choose bond funds for diversification. These they can perform well when the economy and the stock market are down.
- It’s often best to hold bond funds in a tax-advantaged account, such as an IRA or a 401(k).
Bond Funds for Income Purposes
There are several types of bond mutual funds to select from. Many investors choose bonds and bond funds for interest income. Bonds are tagged as "fixed income securities" for this reason. Income translates to interest payments.
A bond will pay you interest, called a coupon, at a stated rate for a given period of time. The period is referred to as the term. You'll receive all interest payments and 100% of your principal back at the end of the term if you hold the bond to maturity and the issuer doesn't default.
A bond fund will hold dozens, or even hundreds, of bonds.
Bonds for Income
Look at the 30-Day SEC yield when you're searching for the best bonds for income. It refers to a yield calculation based on the 30-day period that ends on the last day of the prior month. The yield figure reflects the dividends and interest earned during that period, after expenses.
The SEC yield is the approximate yield that you would receive in a year if each bond in the portfolio was held until maturity. Keep in mind that bond fund holdings (the underlying bond securities) are not held to maturity. Bond funds do not mature. But the 30-Day SEC Yield still provides useful data. It helps estimate the income, shown as a percentage, that's needed for planning.
Bond funds also report the trailing twelve-month yield (TTM). This yield reflects the past and it may not be the same over the coming year. Bond fund yields have seen some record lows in the millennium. This has led to more interest in high-yield bond funds. Also known as junk bond funds, they come with more market risk.
Use caution when you're investing in junk bond funds.
Bond Funds for Diversification
A common reason to invest in bond funds is their diversification. Bond prices move in the opposite direction from interest rates. Prices for bonds often go higher when the Federal Reserve Board signals that it will lower the interest rate that it charges to banks. The Fed often lowers rates when the economy is weak.
Bond funds can perform well when the economy and the stock market are not. Many investors like to include these funds in their portfolios to provide more balance when their stock mutual funds may be falling in price.
The best bond funds for diversification are total bond market funds, such as Vanguard Total Bond Market Index (VBTLX). This fund seeks to mimic the returns of the Bloomberg Barclays Aggregate Float Adjusted Index, a broad bond index covering most U.S. traded bonds and some foreign bonds that trade in the U.S.
Most investors looking for diversification don't search for bond funds with the highest yields. They'll seek funds like VBTLX instead, those that cover all types of bonds at a low cost. They'll at least look for funds with below-average expense ratios.
Choosing an Investment Account
Bond mutual funds are income securities. You'll want to do your best to limit the taxes on that income. It's often best to hold bond funds in a tax-advantaged account like an IRA or a 401(k) if you have that option.
Interest income and capital gains are not taxed while you hold the funds in these accounts. The tax is deferred until you make withdrawals. Bond funds will benefit more from compounding interest as a result, so they'll grow faster.
You might think about investing in municipal bond funds if you have to hold bond funds in a taxable account. The yields for these funds are often less than that of taxable bond funds. But the interest is tax free, at least at the federal level. And it can be tax free at the state level as well if the bonds are issued by the state where you live.
You can look for bond funds that only buy municipal bonds within your state, such as New York municipal bond funds like Vanguard New York Tax-Exempt Fund (VNYTX) if you live in New York.
Matching Funds With Your Objective
You should also be sure that your investment goal and your time horizon match the type of bond fund you select. A short-term bond fund or ultra-short-term bond fund can be a smart choice if you're looking for one that can earn interest higher than that paid by a certificate of deposit (CD) or a savings account. These would also be good choices if there's a chance that you'll want to withdraw some or all of your money within one to two years.
You can invest in almost any kind of bond fund if your holding period is longer than three years.
Remember that bond funds can decline in value. It may be wise to not use them at all in some cases. They wouldn't be a wise choice if you think you'll need to withdraw money in less than one year.
NOTE: The information on this site is provided for discussion only. It is not investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.