What Are Bond Funds?
Bonds funds are professionally managed portfolios that invest in fixed-income securities. We outline how they work and the benefits and disadvantages.
Sean Canonica
Senior Finance Writer
Sean is a finance writer and content strategist for ComparisonAdviser. He has over three years of experience writing about various topics, such as insurance, financial advisors, and investing. Additionally, he is a co-founder and the CEO of RateSonic, an online insurance resource. Sean values helping readers understand difficult topics by creating easy-to-read and thorough content.
View ProfileAs an investor, it’s crucial to ensure your portfolio is diversified in a way that aligns with your goals. One way to accomplish this is by buying shares of an investment company, such as a mutual fund or unit investment trust, that invests in a wide array of securities. Another important type is a bond fund, which comprises fixed-income securities, such as bonds.
This article will detail how a bond fund works and what place it may have in one’s portfolio. This includes what they typically invest in, as well as the benefits and disadvantages of including it in your strategy. Finally, you’ll learn how to buy shares of one of these companies.
Key Takeaways
- Bonds funds are a type of professionally run fund that’s made up of fixed-income securities, such as bonds and debt securities.
- Typically, bond funds are categorized by the types of securities they invest in, such as government, municipal, agency, and corporate bonds.
- Bond funds provide returns for investors based on dividends and realized capital gains, rather than repayment of principal and interest, as with individual bonds.
Understanding Bond Funds
A bond fund is an investment company that buys, holds, and sells bonds and debt securities. Much like a mutual fund, an investor buys shares of a professionally managed fund and receives periodic dividend payments. These distributions are based on the interest bonds generate and the capital appreciation that may occur.
Bond funds invest in a wide variety of fixed-income and debt securities, including:
- Government bonds. These are bonds issued by the U.S. government. They are typically lower risk because they have the full faith and credit of the U.S. backing them.
- Municipal bonds. These are bonds issued by local government bodies to fund city projects, such as establishing buildings or repairing infrastructure. Interest earned is often exempt from federal income tax.
- Corporate bonds. Bonds in this category are typically issued from for-profit companies to raise additional capital. These may be riskier than other types, especially depending on the financial health of the issuing firm.
- Agency bonds. U.S. government agencies, such as the Federal Home Loan Mortgage Corp. (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), issue bonds to fund their operations. These tend to have more risk than government bonds, which are backed by the full faith and credit of the U.S.
Generally, bond funds are classified by the above types of securities. They may, however, also be classified according to their maturity period or payouts. Also, if you would like to see what a fund invests in, you can check its prospectus, which is either available on its website or through your brokerage firm.
Benefits and Disadvantages of Bond Funds
Bonds funds are an efficient and streamlined way to add fixed-income securities to your portfolio. They also provide the potential for fixed income and tend to carry less risk than equity mutual funds. There are, however, some downsides to consider, such as lower returns than equity funds or much less control over the exact securities you want to invest in.
Below is a more specific breakdown of the benefits and disadvantages of investing in a bond fund:
Benefits
- Potential for income within your portfolio.
- Less risk than equity funds.
- Efficient and simpler way to add bonds to your portfolio.
- Professional management allows for a lower-stress way to add bonds to your portfolio.
Disadvantages
- More modest returns than equity funds.
- Not as much control over what individual bonds you’d want to invest in.
- Depending on the type of bond fund, there is a risk that a financial institution may not be able to pay back the principal, plus interest.
- Management fees can cut into your returns.
Bond Funds vs. Individual Bonds
Many investors choose bond funds as a way of adding fixed-income securities to their portfolios. However, it’s also common to select individual bonds. While both are similar, there are key differences and implications of investing in each to be aware of.
When you invest in an individual bond, you are essentially lending a company or organization money over a fixed period. A bond fund, on the other hand, is typically a mutual fund comprising an entire portfolio of bonds. With the former, you are entitled to the principal, plus interest, rather than dividend payouts.
While returns are more direct, buying individual bonds requires more legwork, such as price and interest rate research. Bond funds allow you to dip into fixed-income securities while keeping a more hands-off approach. You do, however, need to pay close attention to the net asset value (NAV) of a bond fund, which may fluctuate.
The best approach for you depends on your investment knowledge, goals, time horizon, and risk tolerance. Before you decide whether to invest in either bonds or bond funds, we recommend speaking with a financial advisor or investment manager to get a clear picture. They can help you avoid mistakes and determine which path is best for your needs.
How to Invest in Bond Funds
You can invest in bond funds through a retirement account, such as a traditional or Roth IRA, as well as a taxable brokerage account. This can be accomplished through a brokerage firm, such as with the following prominent companies:
- Vanguard
- Fidelity
- Charles Schwab
- Merrill Lynch
- J.P. Morgan
Before you invest, there are tax implications you should consider when you buy shares of a bond fund through a taxable account. Because a fund’s NAV may fluctuate, you could owe capital gains tax if you sell shares for a profit. Additionally, you may owe ordinary income taxes or capital gains taxes on dividends or distributions you receive as a result of ownership. Keep in mind, however, that income that a fund earns via municipal bonds is typically exempt from federal and, in some cases, state taxes.
If you need help getting started with investing in bond funds, we recommend meeting with a financial advisor. To find a high-quality one in your area, consider this free matching tool. After filling out a short quiz, it’ll pair you with a vetted professional in your area.
Frequently Asked Questions
Are bond funds worth it?
Bond funds may be worth it if you’d like to add fixed-income securities to your portfolio but prefer the more hands-off approach of a professionally managed fund. In the grand scheme, however, you can expect only modest returns from investing in these types of assets. Be sure to speak with a financial advisor to determine how these fit into your portfolio.
How often do bond funds distribute earnings?
Bond funds often pay out dividends each month. They may also periodically distribute realized capital gains whenever a manager sells off securities in the portfolio. For specific information on how a fund works, be sure to read its prospectus.
What is the main disadvantage of bond funds?
Bond funds typically have management fees that can cut into your returns. This, coupled with less control over how you earn money, can be a downside of investing in a fund over an individual bond.
Do bond funds provide passive income?
Bond funds can provide passive income in the form of dividends, which generally pay out monthly. You may also earn money by selling shares of the fund for a profit. Be aware that both are subject to taxes if you’re using a taxable account to invest.