Investing Articles |
Bond Funds in Your Portfolio
Bonds are popular investment vehicles because they pay interest income with a promise to pay back the initial investment after an agreed-upon period of time. Bond mutual funds may be even more popular among those seeking an income component in their portfolio because they offer a lower-cost, professionally managed, diversified alternative to individual bonds. However, before determining that bond funds will help meet your income needs, compare the goals, similarities, differences, and risks of bonds and bond funds.
What Is A Bond?
A bond is an "IOU" for money loaned by an investor to the bond’s issuer. In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate, known as the "coupon rate." When the loan is paid back at the end of that time period — when the bond "matures" — the issuer’s objective is to repay the investor’s principal.
Because bond prices generally do not move in tandem to stock investments, they help provide balance in an investor’s portfolio. They also seek to provide investors with a steady income stream, often at a higher rate than money market investments.* Zero-coupon bonds are the only exception in that they provide no cash flow but are sold at a deep discount to their face value; the investor then receives the full face value of the bond at maturity. Keep in mind that the market value of zero-coupon bonds fluctuates more than regular coupon bonds; therefore, they may not be suitable for investors with liquidity needs.
Bonds come in a variety of forms, each bringing different benefits, risks, and tax considerations to an investor’s portfolio. Most bonds fall into four general categories: corporate, government, government agency, and municipal. Corporate bonds are issued by corporations and can be among the riskiest of all bonds. On the other hand, government bonds are among the safest because they are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government. The risks associated with government agency and municipal bonds vary, but generally fall in between corporate and government bonds on the risk spectrum.
*An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Bond Mutual Funds: Seeking A Steady Stream Of Income
Combining many different bonds in one portfolio in order to pursue a stated objective, a bond mutual fund can add a diversified fixed-income element to an investor’s portfolio.
Because they are designed to provide a steady stream of income, bond funds are suited to investors seeking to balance the fluctuations of stock investments while striving for protection of principal and higher current income than money market or other stable-value investments. Of course, there is no assurance that these objectives will be met.
These may be most appropriate for investors nearing retirement and those uncomfortable seeing large fluctuations in the value of their investments.
As with any investment, however, investors should consider the risks associated with individual bonds and how they might affect a fund before investing in it.
| Components of Total Return, 1926 – 2006 |
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While stocks have historically provided income and capital appreciation, the total return of bonds has been comprised primarily of interest income. Sources: Standard & Poor’s and Federal Reserve. Based on the 80-year period ended 12/31/07. Stocks are represented by Standard & Poor’s Composite Index of 500 Stocks, an unmanaged index considered representative of the stock market. Bonds are represented by long-term Treasuries (10+ years). Investors cannot invest directly in any index. Past performance is no guarantee of future results. |
Three Potential Risks:
Credit Risk, Market Risk, and Interest Rate RiskSome bonds hold "credit risk," or the risk that the bond issuer will go into default before your bond reaches maturity. In that case, you may lose some or all of the principal amount invested and any outstanding income that is due. Bonds are often rated by Moody’s and Standard & Poor’s (S&P). Ratings run from Aaa (Moody’s) or AAA (S&P) through D based on the issuer’s creditworthiness; Aaa and AAA are the highest credit ratings. Bond funds also can be issued ratings based on the credit quality of their underlying bonds.
Like stocks, all bonds can present the risk of price fluctuation (or "market risk") to an investor who is unable to hold it until the maturity date. If an investor is forced to sell — or liquidate — his bond before it matures, and the bond’s price has fallen, he will lose part of his principal investment as well as the future income stream. Another risk common to all bonds is interest rate risk. When interest rates in the economy rise, a bond’s price will usually drop, and vice versa.
Bond mutual fund investors should consider these forms of risk because the fund manager can buy and sell bonds as often as deemed appropriate by the fund’s objective. Fund investors therefore risk loss because of fluctuations in the value of the fund.
Types Of Bond Funds: Match Your Risk Tolerance
Bond funds also come in a variety of forms, each striving to serve a different purpose based on the underlying individual securities. And like individual bonds, different bond funds hold different risks and sometimes offer tax benefits. Some of the more popular types of bond funds include U.S. government, corporate, and municipal bond funds.Because U.S. government funds are composed of securities backed by the full faith and credit of the U.S. government, they hold virtually no credit risk. They can, however, be affected by changes in interest rates and market conditions and can risk not keeping pace with inflation. U.S. government funds are taxed at the federal level, but are exempt from state tax. These funds generally appeal to investors seeking steady income and solid protection of principal.
Depending on their objective, corporate bond funds may invest in a variety of corporate issues with different, and perhaps even substantial, credit risks. In addition, they can be subject to interest rate and market risk. But remember that more potential risk usually means higher potential yields; therefore, these funds may suit investors who can withstand a bit of risk in pursuit of higher income.
Municipal bond funds generally invest in the higher-quality, federal tax-free issues of state governments and municipalities. Because of their potential benefits when compared with taxable securities, municipal bond funds can be appropriate for investors in the higher tax brackets. These are also subject to interest rate and market risk and may be subject to the federal alternative minimum tax.
Strategies To Help Manage Risk When Investing In Bonds |
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Choose The Fund That Meets Your Need
Although every bond fund comes with its own risk, you should balance the risks with the overall benefits of fund investing: Diversification can help manage overall risk in the fund; professional management can save you the hassle of having to research and evaluate the thousands of individual bonds on the market; and lower initial investment requirements help ease accessibility to a wide variety of bonds.
The best strategy is to work with your financial professional to determine your fixed-income needs, identify a fund that will help meet those needs, and evaluate the risks associated with it. Then you should feel confident that the bond fund you select will help fill the fixed-income need in your portfolio.
Points To Remember
- Bonds provide an income stream and add diversification to a stock portfolio.
- A bond’s total return equals the income it provides plus capital appreciation or loss.
- Bond prices fluctuate with changes in interest rates.
- Bonds are also subject to credit risk.
- Investors can buy both individual bonds and bond mutual funds.
- Holding bonds to maturity manages market risk for individually owned bonds; bond funds will fluctuate in value.
- Investing in bond mutual funds allows individuals to diversify among many different bond issues, thereby helping to manage credit risk.
- You can help manage interest rate risk by investing in shorter-term bonds, or by varying their maturity dates.
