A Guide to Investing in Bond Funds

When companies, governments or other entities need to raise capital, they may issue bonds. In simple terms, bonds are debt securities that a debtor company gives out to its creditors (the bond holders). Investment companies that are organized around bond assets are known as bond funds.

Bond funds primarily invest in debt securities such as zero coupon bonds, mortgage backed securities, convertible bonds, corporate bonds, municipal bonds, or government bonds. Generally, the returns of investing in a bond fund are directly proportional to the risk levels of the specific bonds in which the bond fund is invested.

Common Bond Types

Government bonds: Treasury or municipal bonds (government bonds) backed by the US or local government entail the lowest investment risk. Thus, securities issued by bond funds that have been organized around government bonds also come with a relatively low level of risk.

Of course, since they are low-risk instruments, they also offer low returns. Thus, bond funds organized around government bonds also come with relatively low rates of return. Note, however, that government bonds may be exempt from federal or state taxes, and this makes these bonds (and bond funds invested in them) more desirable.

Bonds guaranteed by government agencies: Low-risk bond products also include mortgage bonds guaranteed by government agencies such as the Federal Home Loan Mortgage Corp or Freddie Mac, the Federal National Mortgage Association or Fannie Mae, and the National Mortgage Association or Ginnie Mae. Bond funds organized around these mortgage bonds, therefore, are also relatively low-risk.

Corporate bonds: A high risk of default comes with bonds issued by public companies. Such bonds' performance depends on their issuer's ability to make good on their loan payments. Nevertheless, these bonds have higher rates of return than government and government-agency bonds. Bond funds primarily invested in corporate bonds, therefore, offer higher rates of returns but also a higher level of risk.

Advantages of Bond Funds

Investing money in a bond fund instead of buying bonds directly hold some advantages.

For one, it is easier to liquidate bond fund investments than individual bond investments. Bond funds are redeemable, whereas bonds are ideally surrendered only upon their maturation.

Bond funds also offer automatic diversification, and this considerably reduces an investor's risk. Direct bond investment, on the other hand, requires the extra step of allocating and diversifying bond assets.

Finally, bond funds have fund managers. Investors in a bond fund don't need to pick and choose specific bonds since the bond fund manager/sponsor has already chosen the bonds that will go in their securities portfolio. Prior to investing in these bonds, moreover, the bond fund manager/sponsor has already analyzed them for potential gains, creditworthiness, face value, coupon rates, and all the other important factors that direct bond investors must consider.

Risks of Investing in Bond Funds

As with any other investment, bond funds also have risks and these should be disclosed in any bond fund's prospectus. You should take the time to read a bond fund's prospectus as well as its most recent shareholder's report before investing in it.

The following are some of the risks involved in bond (and therefore bond fund) investing:

Prepayment: When interest rates fall, there is a risk that the issuer of the bond will take advantage of this and pay the bonds in full. Some bonds don't have this prepayment option, however.

Interest Rates: Interest rates usually adversely affect the market value of a bond fund's assets. This means that when interest rates go up, the value of a fund's bonds generally declines. As such, investors in a bond fund stand to lose money when there is a significant increase in interest rates.

Investors holding bonds with longer maturities are more exposed to the risk of rising interest rates than investors holding bonds with shorter maturities.

Default: As with any other debt instrument, there is a risk of default from the bond issuer. This risk is higher in corporate bonds. If a company files for bankruptcy, for instance, its assets may not be enough to pay for all its outstanding debts - and bondholders get paid only after secured creditors have been paid.

The risk of default, however, is minimal for government bonds and bonds backed by government agencies.

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