Bond Funds Safety
Bond funds are a type of investment company (it can be a mutual fund, a unit investment trust or closed-end fund) that invests mainly in bonds or other debt securities. Generally, bond funds pay periodic dividends, which include interest payments on the fund's securities and periodic realized capital appreciation.
Depending on their investment objectives and policies, bond funds may focus on one or several different types of bond or debt security, such as municipal bonds, corporate bonds, government bonds, convertible bonds, zero-coupon bonds, mortgage-backed securities. Thus, the risk and return of the different types of bond funds also varies.
Risk of Investing in Bond Funds
A common misconception among many investors is that bond funds present little or no risk. However, bond funds are no different than any other type of investment and are subject to a number of investment risks, such as:
Interest rate risk
As interest rates move up and down the market value of the bonds that the bond fund owns also fluctuates. Fund holding bonds with longer maturities are considered riskier in this respect than those holding bonds with shorter maturities.
Interest rate risk may cause the loss of money even for bond funds that invest only in government bonds or insured bonds.
Credit risk is associated with the possibility that the issuers of the bonds may default (in other words failure to pay off the debt they owe on the issued bonds).
Funds investing in U.S. government bonds or insured bonds don't have worry much about this type of risk.
Prepayment risk relates to the possibility that the bond issuers may prepay the bonds at a time when the interest rates are lower. This means that the fund may have to reinvest the proceeds also at lower interest rates, which may reduce its return.
Have in mind that not all bonds may be prepaid.
Before investing in a bond fund, read carefully the bond fund's prospectus (it should disclose these and any other risks) and all of the fund's available information (for example its most recent shareholder report).
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