Why Investors Buy Bond Funds
Selecting an appropriate bond fund requires applying a few principles which allow an investor to narrow the choices and select the best bond mutual fund appropriate for his investment goals. These principles assume the investor has a basic understanding of the different types of bonds: government, municipal and corporate bonds.
Principle One: Bond fund share prices will go down when interest rates increase. This risk is reduced by buying bond funds holding short or intermediate term bonds. The trade-off for principal safety is a lower yield. This risk is the downfall of the bond fund investor who buys a government bond fund for safety but picks a fund holding longer term bonds for the higher yield. When rates increase the fund share price declines significantly, leaving the investor wondering what went wrong. The interest rate risk of a fund can be determined by looking up the average duration or maturity of the fund's portfolio.
Principle Two: High yield means low credit quality. High yield bond funds make those yields by owning non-investment grade bonds. These bonds have a significantly higher risk of default than investment grade bonds. Bond funds are probably the best way to invest in the high yield market, letting professional money managers pick the bonds. However, an investor must be aware of the higher level of risk. A high yield fund can go along for years earning investors excellent returns. However, the breakdown of high yield bonds tends to happen rapidly in times of economic recession.
Principle Three: Bond fund expenses matter. A higher bond fund expense ratio directly reduces the dividend yield of the fund. Consider two funds with similar duration and credit quality. One fund has expenses of one percent and the other a half percent. The fund with lower expenses will yield a full half-percentage point higher. On a $100,000 bond fund account, that is an extra $500 in dividend earnings every year. There must be very compelling reasons to select a bond fund with higher expenses than the 2010 national bond fund average of 0.72 percent.