How To Choose the Right Bond Funds

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If you're looking to invest in bonds, buying bond funds are a great way to do so. However, one of the most important aspects of investing in bond funds is understanding the differences in the types of funds and the risks and return characteristics of bonds with different maturities.

Key Takeaways

  • Bond funds can be classified based on their structure, the kinds of bonds they invest in and the maturities of the bonds in their portfolio
  • Government bonds are considered less risky compared to corporate bonds. High-yield bonds offer higher interest rates but carry larger risk of default.
  • Short-term bonds mature in fewer than five years, intermediate-term bonds mature between four and 10 years, while long term bonds mature over 10 years or more.
  • Bonds with longer maturities carry higher interest rate risk, meaning their returns are more sensitive to changes in interest rates.

Types of Bond Funds

Mutual funds are a basket of selected investment tools that investors can pool their money into. Bond mutual funds, as the name suggests, invest in bonds. They can be actively or passively managed and can be built to follow bond indexes or other investing strategies.

Bond mutual funds can consist of all of one type of bond with the same maturity dates or a mix of many with different maturities. Managers can add new bonds to the fund or trade out lower-performing bonds to keep the fund in line with the management's strategy.

You can classify bond funds into different categories based on a couple of criteria such as structure, the kind of bonds they invest in and the maturities of the bonds they invest in.

Based on Fund Structure

Based on how they are organized, there are four types of bond funds— open-ended bond mutual funds, closed-end bond funds, exchange-traded bond funds, and bond unit investment trusts.

Note

Open-ended bond funds are the most common types of bond mutual funds that allow you to buy and sell as you see fit within the fund.

Closed-end bond funds have a set number of bonds in the fund. These funds are known to perform well during bond favorable market conditions, but since managers can use leverage (borrow funds from the investors) to purchase the assets, unfavorable market conditions can bring significant losses.

Exchange-traded bond funds trade on the stock markets and can be purchased like stocks through brokerages. Bond unit investment trusts are more typical of what is commonly thought of as bond investing—bonds in a fund are held in a trust to their maturity date. When each bond matures, the fund distributes any proceeds.

Each type of bond fund structure can have funds that hold bonds of a particular type or maturity.

Based on Fund Investments

Bond funds can invest in a specific type of bond or multiple bond types. The types of bonds that funds invest in include U.S. government bonds, municipal bonds, corporate bonds, high-yield bonds and international bonds.

Each type of bond has a different risk profile and some may even offer a tax benefit. For example, U.S. government bonds are considered less risky compared to corporate bonds. High-yield bonds offer better interest rates to compensate for higher risk of default. And income from municipal bonds is generally exempt from federal income taxes, though state and local taxes may apply.

Based on Fund Portfolio Duration

Bonds mature in periods referred to as maturities, at which time proceeds are usually paid. Bond maturities typically fall into one of three categories:

  • Short-term (one to three years, less than five years)
  • Intermediate-term (four to 10 years)
  • Long-term (more than 10 years)

Some bond funds focus on a particular bond duration while others may invest in multiple bonds with varying maturities.

Choosing A Bond Fund

While making any investing decision, investors should typically consider certain basic factors— risks, costs and potential returns. When investing in bond funds, the risks arise out of the type and duration of bonds the fund is investing in.

Since we've discussed the risk-profile of bonds based on. who's issuing them in the section above, let's take a closer look at the risks of bond funds based on the maturities of the bonds in their portfolio.

Short-Term Bond Funds

Virtually all bonds with maturities of more than a year are subject to the risk of price fluctuations stemming from interest rate risk. The longer the time until maturity, the larger the potential price fluctuations. The shorter the time until maturity, the lower the price fluctuation probability. Short-term bond funds tend to have lower risk and yields.

Note

Short-term bond funds are useful for someone who needs liquidity in the near future.

Also, short-term yields are more affected by the policy of the U.S. Federal Reserve, whereas market forces primarily determine the performance of longer-term bonds. Since investor sentiment changes much more rapidly than Fed policy, this leads to more intense price fluctuations for long-term bonds.

Intermediate-Term Bond Funds

As their name would suggest, intermediate-term bond funds fall roughly in the middle for risk and returns. Intermediate-term bond funds are by far the largest of the three categories.

Note

Index funds and funds that tend to invest across the full spectrum of the bond market tend to average out to an "intermediate" maturity. Take care to distinguish between funds that fit this description versus those dedicated explicitly to intermediate-term bonds.

Long-Term Bond Funds

Longer-term bond funds typically offer higher yields but also greater risk. The risk stems from interest rates, which are affected by inflation. This risk is called interest rate risk. Long-term bonds lock up an investor's money for a longer period than a short-term bond, which leaves more time for interest rate movements and inflation to affect the bond's price.

When interest rates rise, bond yields go up but bond prices fall. When bond prices fall, the returns of bond funds decline. When rates are fall, longer-term bonds will produce higher total returns.

According to FINRA, a one percentage point change in interest rates will typically affect the price of the bond in the opposite direction to the extent of its duration. For example, if interest rates go up by one percentage point, the price of a 10-year bond will fall by approximately 10%. If the interest rates go down by one percentage point, the price of the 10-year bond will rise by nearly 10%.

Note

Long-term bond funds are excellent if you can withstand the ups and downs of the market and have time to wait for your money.

Bond Performance and Fluctuating Interest Rates

Here's an example of how the rate movements affect the returns of bond funds with different maturities. Between March and July 2022, the Federal Reserve hiked rates four times, raising rates by a total of 225 basis points.

According to data from Morningstar, between the start of the year till Sep.t 13, 2022, here are the returns for different types of bond funds:

Type of Bond Funds Performance Jan.1 -Sept. 13, 2022
 Ultrashort-term Bond Funds  -0.89%
 Short-term Bond Funds  -4.97%
 Intermediate Core Bond Funds  -12.10%
 Long-term Bond Funds  -22.22%

Determining What's Best for You

Investors typically adjust their portfolios toward one end or the other based on their risk tolerance, objectives, and time frame.

For instance, an investor for whom safety is the top priority would typically sacrifice some yield in exchange for the greater stability and lower risk of loss present in short-term bonds. On the other hand, an investor with higher risk tolerance and more time until they needed to tap into their principal could take on more risk in exchange for the higher yields available in long-term bonds.

There’s no single right answer as to which approach is the better choice; it depends on the individual's situation. However, it's essential to keep in mind that long-term bond funds aren't appropriate for someone who needs to use the principal within three years or less due to their higher volatility.

Frequently Asked Questions (FAQs)

How do bond funds work?

Bond funds are a pooled investment product that involves many investors contributing money to the same pot of investments. The money invested into the bond fund is controlled by fund managers who decide what kinds of bonds to buy and when to buy or sell bonds (in exchange for fees taken out of the fund). While there may be differences in trade orders or fees, investors are generally able to deposit and withdraw money from the fund as they please.

When do bond funds do well?

This question depends in part on your goals with the bond fund. If you're primarily concerned with income, you might prefer for interest rates to rise, which would result in higher yields from bond funds. However, as bond yields rise, the prices fall. If you're primarily concerned with protecting your portfolio against downturns, you might prefer for interest rates to fall and push up bond prices.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. FINRA. "Bond Funds."

  2. Fidelity Investments. "Types of bond funds."

  3. FINRA. "Bonds."

  4. FINRA. "Brush Up on Bonds: Interest Rate Hikes and Duration."

  5. Board of Governors of the Federal Reserve System. "Policy Tools."

  6. Morningstar. "Why 2022 Has Been Such a Terrible Year for Bond Funds."

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