Bond Funds and Income Funds
March 29, 2010
What is a bond fund?
"Bond funds" and "income funds" are terms used to describe a type of investment company (mutual fund, closed-end fund or unit investment trust (UIT)) that invests primarily in bonds or other types of debt securities. Depending on its investment objectives and policies, a bond fund may concentrate its investments in a particular type of bond or debt security—such as government bonds, municipal bonds, corporate bonds, convertible bonds, mortgage-backed securities, zero-coupon bonds—or a mixture of types. The securities that bond funds hold will vary in terms of risk, return, duration, volatility and other features.
Can I lose money investing in a bond fund?
Yes. A common misconception among some investors is that bonds and bond funds have little or no risk. Like any investment, bond funds are subject to a number of investment risks including credit risk, interest rate risk, and prepayment risk. A bond fund’s prospectus should disclose these and any other risks. Before investing in a bond fund, you should carefully read all of the fund’s available information, including its prospectus and most recent shareholder report.
What is credit risk?
Credit risk is the risk that the issuers of the bonds owned by a fund may default (fail to pay the debt that they owe on the bonds that they have issued). This risk may be minimal for funds that invest in U.S. Government bonds.
What is interest rate risk?
Interest rate risk is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. For example, when interest rates go up, the market value of bonds owned by a fund generally will go down. Nearly all bond funds are subject to this type of risk, but funds holding bonds with longer maturities are more subject to this risk than funds holding bonds with shorter maturities. Because of this type of risk, you can lose money in a bond fund, including those that invest only in insured bonds or U.S. Government bonds.
What is prepayment risk?
Prepayment risk is the risk that the issuers of the bonds owned by a fund will prepay them at a time when interest rates have declined. Because interest rates have declined, the fund may have to reinvest the proceeds in bonds with lower interest rates, which can reduce the fund’s return. (Not all bonds, however, can be prepaid.)
Will I receive tax advantages if I invest in a municipal bond fund?
Some bond funds invest in municipal bonds that pay interest which is exempt from federal income taxes. In addition, interest on the bonds of some states are exempt from taxation by that state. Not all of the income that you receive from a municipal bond fund, however, will necessarily be exempt from federal or state income tax. The fund’s prospectus will describe any of its tax-exempt features.
What is an ultra-short bond fund?
Ultra-short bond funds are mutual funds that generally invest in fixed income securities with extremely short maturities, or time periods in which they become due for payment. Like other bond funds, ultra-short bond funds may invest in a wide range of securities, including corporate debt, government securities, mortgage-backed securities and other asset-backed securities.
Some investors don’t realize that there are material differences between ultra-short bond funds and other investments with relatively low risks, such as money market funds and certificates of deposit. Specifically, ultra-short bond funds tend to have higher risks than money market funds and certificates of deposit (CDs).
To learn more about ultra-short bond funds, including some of the material differences between these funds and other investments, you should read Ultra-Short Bond Funds: Know Where You’re Parking Your Money.