A bond fund invests in a portfolio of individual bonds suitable for meeting the fund’s objective.
When you put money into a bond fund, you buy shares in the fund, just as you do when you put money into a stock fund. The fund manager invests that money by buying bonds issued by corporations, governments, or government agencies.
When issuers sell bonds, they’re actually borrowing money from investors who are willing to lend for a specific period of time, called the bond’s term. In exchange, the investors receive interest on the loan and the promise that the principal, or loan amount, will be returned by a specific date, called the maturity date.
Since the issuer owes the investors money, bonds are also called debt securities. It’s a way to distinguish them from equity securities, or stocks, which give investors partial ownership.
Types of bond funds
You differentiate bond funds from each other in two ways: by the type of issuer and by the average term of the bonds in the fund. 401(k) plans generally offer four categories of bond funds:
- US Treasury funds, which invest in bills, notes, or bonds issued by the federal government
- Agency funds, which invest in bonds issued by agencies that are part of or affiliated with the federal government
- US corporate funds, which invest in bonds issued by US companies of various sizes
- International funds, which invest in bonds issued by corporations based overseas or by governments other than the United States Funds may focus on bonds of different terms, grouped by average maturities:
- Short-term funds, which have an average maturity of one to two years
- Intermediate-term funds, which have an average maturity of two to ten years
- Long-term funds, which have an average maturity of ten years or longer
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Complex interest and fund prices
In most cases, if you own an individual bond, the rate of interest you earn remains the same for the term of the loan. But that’s not the case with a bond fund.
While each bond that a fund owns pays a fixed rate of interest, every bond in the fund — and there may be dozens — is likely to be paying at a different rate. In addition, the fund’s portfolio of bonds is always in flux, so that the collective rate the fund earns on one day may not be the same as its collective rate the next day.
As interest rates change in the economy at large — going higher in some periods and dropping in others, often in response to policy decisions by the Federal Reserve — the interest rates a bond fund earns and the distributions it makes to its shareholders reflect these changes.
Fluctuating interest rates also affect a bond fund’s net asset value (NAV), or price per share. When rates drop, the share price of a bond fund increases because the bonds it owns, which pay a higher rate of interest than new issues in the market, increase in value. The reverse is also true. When rates rise, share prices of bond funds drop because newly issued bonds pay a higher rate than the bonds the fund owns. price and yield Yield is a measure of what you earn on a bond fund. When you own an individual bond for its full term, your yield is the same as the interest rate the bond pays. But when you own a bond fund, your yield changes as the fund’s NAV changes. The yield drops as the NAV rises, and rises as the NAV drops.
Variation on a theme
Bonds are often described as fixed-income investments. That’s because most bonds pay a fixed rate of interest on a fixed schedule. But it’s not really accurate to describe a bond fund as a fixed-income investment, since the interest rate you earn varies from payment to payment as the fund’s portfolio of bonds changes.
As a bond fund’s NAV changes in response to changes in interest rates, the market value of your holding in the fund changes as well. In a simplified example, if you bought 100 shares with a NAV of $10, your account value would be $1,000. But if the NAV dropped to $9.75 because of rising interest rates, your account value would be $975. That’s an example of interest rate risk.
In addition, the value of a bond also changes based on supply and demand. An existing bond is worth more when rates drop because investors will pay more than its par value, or price at issue, to own it, so they can earn the higher interest rate it pays. And they’ll pay less for existing bonds when rates rise because they can earn better rates on newer issues.
Yield and Return
Yield is a measure of what you earn on a bond fund. When you own an individual bond for its full term, your yield is the same as the interest rate the bond pays. But when you own a bond fund, your yield changes as the fund’s NAV changes. The yield drops as the NAV rises, and rises as the NAV drops.
From an investment perspective, what matters most about owning shares in a bond fund is total return — the interest you earn plus any increase or decrease in the value of your principal. The greater your total return, the better your investment is doing. The longer a bond fund’s average maturity, the more sensitive it is to changes in interest rates. Thus, a long term bond fund has greater potential than a short-term bond fund to generate high total returns when rates are declining, and low total returns when rates are rising.
Higher-yielding issues, sometimes known as junk bond funds, or more politely as high-yield funds, are generally the most volatile. The interest rate they offer is high, which can boost total return, but their underlying investments can decline precipitously in value.
Bonds vs Bond Funds. Which One Is Better For 401k? by Inna Rosputnia
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