Bond mutual funds are an excellent diversification tool for investors’ portfolios. Bond funds make good compliments to stock funds because bonds are lower in relative risk than stocks, and they have a low correlation in performance trends. This bond profile means that bond funds may have positive returns while stocks are going through a bear market.
Bond mutual funds come in many shapes and styles. Let’s start with five basic types of bond mutual funds while providing examples of quality bond funds.
- You can use the different types of bond funds to create diversity in the bond portion of your portfolio.
- High-yield bonds and international bond funds are generally higher-risk funds but can have higher returns.
- Investment-grade bond funds, Treasury Inflation-Protected Securities bond funds, and Municipal bond funds are generally lower risk.
Investment-Grade Corporate Bond Mutual Funds
High-quality corporations issue investment-grade corporate bonds to raise capital for the corporation. These bonds are typically rated BBB and above by S&P or Baa and above by Moody's. Investment-grade corporate bond mutual funds allow investors to gain access to a diversified basket of corporate bonds, reducing risk (credit risk, interest rate risk, and reinvestment risk).
Many mutual fund companies offer investment-grade corporate bond mutual funds with various durations and maturities. Several Vanguard funds are listed below:
- Vanguard Short-Term Investment-Grade
- Vanguard Intermediate-Term Investment-Grade
- Vanguard Long-Term Investment-Grade
High-Yield Bond Mutual Funds
High-yield bonds are often referred to as “junk bonds” due to their low credit ratings. These bonds are issued by corporations and are rated below BBB by S&P or below Baa by Moody’s. High-yield bonds typically have higher yields than investment-grade corporate bonds due to the additional credit risk that is taken by the buyer of the bonds. So, remember, the high yield comes with higher yields but higher risk.
Here are a couple of high-yield bond mutual funds:
Treasury Inflation-Protected Securities (TIPS) Bond Mutual Funds
TIPS are bonds issued by the US Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index (a measure of inflation). So, TIPS are said to keep pace with inflation by returning the adjusted principal upon maturity and coupon payments along the way. There are pros and cons to TIPS mutual funds.
Here are some TIPS bond mutual funds:
- Vanguard Inflation-Protected Securities Fund
- T. Rowe Price Inflation-Protected Bond Fund
- Fidelity Inflation-Protected Bond Fund
Municipal Bond Mutual Funds
Municipal bond mutual funds hold bonds that are issued by municipalities such as cities and states. Municipal bonds generally receive favorable tax treatment. The interest on most municipal bonds is tax-free at the federal level and is tax-free for investors who buy municipal bonds that are issued within their state of residence. There are also private-activity municipal bonds.
Investors that live in California, Massachusetts, New York, and several other states, have many options to invest in double tax-free municipal bond mutual funds (Federally and state tax-free). Other investors will find national municipal bond mutual funds to be of value.
Generally, except for extreme circumstances, municipal bonds have a lower yield than taxable bonds of similar credit quality, making it necessary to understand tax-equivalent yields. Here are a couple of municipal bond mutual funds:
International Bond Mutual Funds
Just like it sounds, international bond mutual funds invest in bonds issued by foreign entities. Investors can take advantage of a depreciating US dollar by purchasing an unhedged international bond mutual fund. All else being equal (bond yield and bond price), if you own a foreign bond and the US dollar loses ground to that foreign bond’s currency, you will gain/lose based on the foreign currency’s appreciation/depreciation. There are also bond mutual funds that practice currency hedging—to avoid the inherent volatility of currency prices.
Here are a few international bond funds:
A Final Word on Bond Mutual Funds
Before you invest in a bond mutual fund, there are a few items to consider, such as your investment objectives and tolerance for risk. Are bond funds right for you?
Investors are wise to consider using several bond fund types complemented with different types of stock mutual funds to build a diversified portfolio.