A bond fund–sometimes referred to as an income fund–is a type of investment that uses pooled money from a number of investors to purchase interest-bearing or dividend-producing securities. These investments include government or corporate bonds, bank certificates of deposit, preferred stock and commercial paper, according to the U.S. Securities and Exchange Commission. There are significant advantages and disadvantages to investing in bond funds.
Income
Most bond funds seek to provide investors with a steady stream of income while preserving their initial capital investment. Bond funds work by investing in income generating securities and then passing on the accrued interest and dividends to the funds shareholders on a regular basis.
The investor’s rate of return is typically determined on the date the investor purchases shares of the fund. The advantage to the investor is the knowledge of a specific rate of return. The investor may suffer if the interest rate in the general market increases after he invests, which will typically result in a commiserate decrease in the value of the mutual fund shares.
Risks
Bond funds are typically considered less risky than stock funds, according to The Motley Fool website. This type of investment tends to fluctuate, based on the rate of inflation and the rising or falling interest rates rather than on the day-to-day economic news, making the price-per-share less unstable than stock funds. This is important for those who seek capital preservation.
Bond funds may invest only in U.S. government-backed securities, which have the highest of all safety ratings. The SEC warns that not all bond funds have safety or capital preservation as part of their investment objective. High-yield bond funds may seek to maximize their return by investing in low-rated junk bonds, which have a much higher risk of default. The SEC advises all investors to read the fund’s prospectus and most recent shareholder report prior to investing carefully.
Diversification
The primary rule of investing is diversification, sometimes referred to by the old adage, “Don’t put all your eggs in one basket.” Bond funds provide individual investors with a diversified portfolio of bonds that help to defray the risks. Bond funds also provide individual investors with professional management of their assets. There is a cost to this diversification and management, according to The Motley Fool website. Investors who purchase individual bonds typically pay a one-time commission to their broker and then have no additional expenses. Investors who purchase U.S. government bonds do not pay any sales charges. Investors who purchase bond funds may or may not pay a load–or sales–charge, but a portion of their investment goes to pay the management fee. This is typically charged on an annual basis, and it may cost much more than the initial sales charge over time.
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- savings bonds image by Stephen VanHorn from Fotolia.com
