Also called “debt funds”, bond funds are investment vehicles made up entirely of debt instruments. They take the form of mutual funds or exchange-traded funds (ETFs), aggregating fixed-income and other debt securities to provide investors with both a hedge against stock market volatility and access to passive income.
JThese funds have a traditionally conservative investment style: low risk, low reward. However, they can serve both as a complement to a balanced portfolio strategy or as the foundation of a passive income portfolio for retirees. The current bond fund landscape includes a wide range of fund types and strategies, all focused on debt instruments: from US Treasuries to junk bonds.
Here’s an overview of what these funds are, how they work, and some examples of different fund options investors can choose from.
What’s in a bond fund?
As their name suggests, bond funds can and do hold any number of debt securities. Some of the more common assets include US Treasuries, corporate bonds, junk bonds and Treasury Inflation Protected Securities (TIPS).
However, not all funds will contain the same range of assets. The advantage of these funds is a diverse range of options designed to suit different investment profiles and preferences. Here are some examples :
- Company funds
- Emerging Markets Funds
- Global Funds
- High Yield Funds
- Mortgage-backed securities funds
- Municipal funds
- US Government Bond Fund
For example, an investor may choose a fund comprised of TIPS as a way to hedge against inflation. Someone with a little more risk tolerance can buy into a fund made up of higher-interest corporate bonds. The composition of the fund depends on the strategy used to architect it. The time horizon, risk factors, type of bond and more all contribute to whether a debt security makes it a bond fund.
The objectives of a bond fund
Bond funds have two primary goals: to generate passive income and to hedge against stock market volatility. How investors take advantage of these two benefits depends on their investment strategy.
- Passive income. Retirees and investors seeking passive income invest in funds because of their effectiveness. Bond funds hold a collection of bonds with varying coupon rates and maturities, allowing for a smoother flow of income, even when compared to a bond ladder. As the fund’s assets mature and it adds new bonds, investors benefit from fluctuating monthly coupon payments.
- Hedging against risk. As low risk, low return investments, bonds have historically been less volatile than stocks. The added diversity that comes from a bond fund makes them even more stable in the face of volatility. As a result, many balanced portfolio investors use bond funds to hedge against a larger equity portfolio. Although interest rate risk is still a factor for investors to consider, it is much less prevalent.
These two objectives make bond funds one of the most stable investments. And while it is possible to vary the risk and reward levels depending on the type of fund, such as a TIPS-focused safe fund versus an emerging market bond fund, investors can still expect a relative reliability of these products. They are designed to be pillars of the portfolio.
What is a mutual fund?
A mutual is a diversified investment vehicle actively managed by a fund manager. These funds generally have minimum redemption requirements and shares sell at the net asset value (NAV) of the fund. Investors pay an annual management fee to own mutual fund shares, called the expense ratio. The main advantage of bond mutual funds is active management: adjustments to the fund’s allocation based on changes in solvency or interest rates.
Bond mutual funds focus specifically on debt securities. The fund holds hundreds, if not thousands, of different fixed income assets with varying maturity dates, with varying coupon rates. These mutual funds pay monthly lump sum coupon payments, making them excellent passive income investment vehicles for retirees.
What is an Exchange Traded Fund?
An ETF functions similar to a bond mutual fund, with a few key differences. ETFs have no minimum redemption amount, which makes them more liquid and accessible to ordinary investors. They also generally have much lower expense ratios because they are not actively managed. Instead, they are pegged to an underlying bond index.
The benefits of a bond ETF are largely the same as those of a mutual fund, with a higher risk-reward ratio. Without management, investors in bond ETFs expose themselves to interest rate risk unless they actively monitor their investments. However, lower fees and better liquidity make bond ETFs easier to capitalize on, especially since ETF prices change throughout a normal trading period.
How to capitalize on bond funds
Bond funds offer two important benefits to conservative investors: passive income and a hedge against volatility. Together, these factors make them ideal for passive income investors such as retirees. Those seeking bond exposure within a balanced investment portfolio will find themselves drawn to funds with higher risk-reward ratios, such as high-yield bond funds. In both cases, these funds are used to create stability.
Whether you invest in a bond mutual fund or a bond ETF depends on your preferences. Long-term investors tend to see value in paying for managed funds, especially if a mutual fund’s passive income is consistent and significant. Investors who want more control over their exposure to debt securities will appreciate the liquidity and low-cost nature of ETFs. Either way, bond funds are one of the best ways to get broad exposure to fixed income securities without buying individual bonds.