Understanding Bond Mutual Funds

Bonds offer many benefits for a diversified portfolio.  Despite challenging market conditions, fixed income investments continue to help control risk in equity-focused investment portfolios. To help you understand bond funds and how they may fit into your own portfolio, let’s take a closer look at these fixed income investments and how they compare to similar options. Definition of a Bond Mutual Fund Bonds are the underlying investments of bond funds.  A brief explanation of bonds is helpful to understanding bond mutual funds. A bond is a debt security.  When you buy a bond, you’re lending money to the government entity or corporation issuing the bond.  In exchange, you typically receive regular interest payments and the return of the bond’s principal value on a specified maturity date.  Although typically less volatile than those of stocks, bond prices change on a daily basis.  A bond’s current price is dependent on a variety of factors, including market supply and demand, interest rates and the bond’s own credit quality and maturity date. A bond fund is a mutual fund that invests in a portfolio consisting primarily of one or more types of bonds.  Instead of paying interest, as individual bonds do, a fund may pay dividends on a monthly or other periodic basis.  While the investment objectives of bond funds vary, portfolio managers commonly seek to maximize current income and/or total return (see insert) while attempting to stay within stated risk limits. Most investors look at both yield and total return.  Yield is a measure of the income generated by the securities in the fund’s portfolio during a specific period.  It is normally calculated on a monthly basis.  Total return is a measure of both the income earned and the capital gain or loss produced as the underlying bonds’ market volumes change day to day. You will notice that net asset value of a bond fund may change every business day due to the fluctuating prices of the fund’s underlying bond holdings. Bond Fund Performance:  Yield and Total Return Bond investment returns are comprised of two parts.  The first is yield, which is the income provided by a bond.  It is expressed as a percentage of its purchase price.  For example, a bond that costs $1,000 and pays $70 a year has a yield of 7%.  Total return is a broader measure, which takes into account income and capital gains on the fund’s bond portfolio.  In this same example, if the $1,000 bond is now worth $1,020, an investor would realize a gain of $20, in addition to the $70 of income.  Overall, the bond’s total return is $90 or 9%.  This example assumes reinvestment of all income. Many Types of Bond Funds Bond funds may consist of one or more of the following types of bonds: U.S. Government Bonds Issued or backed by the “full faith and credit” of the U.S. Government or its agencies, these bonds have a higher degree of safety from default and, consequently, provide low yields relative to other types of bonds.  In addition, interest on most, but not all, U.S. Government bonds is exempt from state and local taxes. Municipal Bonds Issued or backed by local and state governments, municipal bonds pay investors income that may be exempt from federal and, in some cases, state and local taxes.  As a result of this tax advantage, the interest rate on municipal bonds is usually less than that on fully taxable bonds of comparable quality and maturity. Asset-backed Securities (ABS) Asset-backed securities are bonds collateralized by assets that are not mortgage loans.  The most common types are those backed by automobile loans and credit card loans.  There are also securities backed by boat loans, recreational vehicle loans, computer leases, accounts receivable and Small Business Administration loans. Mortgage-backed Securities (MBS) Mortgage-backed securities are debt issues or bonds secured by pools of mortgages.  Mortgage loans made by banks and savings and loan associations are pooled together and sold to investors.  Each investor purchases an undivided interest in the pool and receives interest and principal payments from the underlying mortgages. Corporate Bonds Issued by corporations, these securities vary widely in yield, maturity and credit quality, depending on the issuing companies’ creditworthiness and other factors. Foreign Bonds Issued or backed by various foreign corporations or governments, these bonds may trade overseas and may be denominated in either a foreign currency or in U.S. dollars.

What Makes One Fund Different from Another? Three major characteristics distinguish bond funds: Type Some funds invest in a single kind of bond, while others seek their objectives through several types.  For example, a high yield bond fund may invest in certain bonds issued by corporations. Average Maturity The average maturity of a bond fund is determined by the fund’s assets on a dollar-weighted basis.  A fund’s average maturity is typically kept within a certain range and generally falls into one of the following categories: short term (one to five years), intermediate term (five to 15 years) or long term (15 years or more).  Longer-term bonds tend to have higher yields as well as greater volatility. What Can Make a Bond Fund Fluctuate? Bond funds are generally subject to several major risks:Interest rate risk This is the chance that interest rates will rise and depress the prices of bonds that were issued when rates were lower.  The longer a bond fund’s average maturity, the greater its interest rate risk.Credit risk This risk reflects a bond’s potential for default.  Bond fund managers try to manage credit risk through careful selection and diversification.Inflation risk This is the possibility that returns won’t outpace inflation by a sufficient margin to meet an investor’s financial goals.  Historically, bonds have produced returns with a much smaller edge over inflation that stocks.Currency risk This is the possibility that an investment in a foreign bond fund will be affected by changes in the value of the local currency relative to the U.S. dollar.  Exchange rate fluctuation will affect total returns upon conversion back to the U.S. dollar. Credit Quality Credit quality refers to the bond issuer’s ability to make interest or principal payments on its debt.  Bonds with higher risk of default are considered lower quality and usually offer a higher rate of interest to compensate for this risk.  The opposite is true of higher quality bonds. The credit quality of a bond may be evaluated by an independent rating agency.  Several of these firms, most notably Moody’s and Standard and Poor’s, assess issuers in terms of their creditworthiness, assigning a letter or letters to denote their ratings.  The highest bond ratings given by these two agencies are Aaa and AAA, respectively.  Bonds that are rated Ba or lower by Moody’s, or BB or lower by Standard and Poor’s, are know as “high yield” or “junk” bonds.  These are subject to greater risk than investment-grade securities, including an increased risk of default. Comparing Bonds to Other Income Investments In pursuit of current income, investors frequently consider money market funds, CDs and bond funds.  While all offer an ongoing stream of income, they differ in terms of their structure, risks and rewards. Money market funds, for example, seek to maintain a stable price of $1.00 per share, which can make them a good parking place for cash that may be needed on short notice.  (Of course, there can be no assurance that a fund will be able to maintain this share value.)  Their yields, however, vary with market conditions and are usually lower than those on CDs or bond funds.  Even though shares of a money market mutual fund are neither insured nor guaranteed by the U.S. Government, these funds are normally managed to maintain safety of principal and, thus, can play an important role in an investor’s portfolio. CDs ordinarily pay a fixed rate of interest that is higher than that of most other types of bank accounts.  And, unlike money market funds, the original principal may be insured by the FDIC.  The drawbacks?  Money must be left on deposit for a specific period.  If it’s withdrawn before the CD matures, the investor usually pays a penalty.  And, if interest rates rise, the depositor is locked into the lower CD rate.  In general, the longer the term of the CD, the greater its rate of interest. Bond funds commonly have higher yields than either money market funds or CDs.  Keep in mind, though, that neither the yield nor the share price of a bond mutual fund is insured or guaranteed; both fluctuate as market and economic conditions change.  Because the principal value of a bond fund’s shares changes over time, investors may enjoy a capital gain or suffer a capital loss – a feature which makes these funds distinctly different from CDs and money market vehicles. Bond Funds vs. Bonds Investors who like the advantages of bonds may find the advantages of a bond fund even more attractive. A bond fund invests in dozens or even hundreds of different bonds - it offers instant diversification.  In contrast,

building a diversified bond portfolio on one's own can be daunting, considering that bonds are often sold in large-and expensive-units. In addition, a fund is managed by a team of professionals chosen for their expertise in the selection and management of a particular type of bond.  And, not surprisingly, they often have access to information that individuals find difficult to obtain. Dividend payments and their reinvestment are still other fund benefits.  Bond fund investors typically receive dividend payments on a monthly basis, while bond holders frequently receive their interest checks just twice a year.  These dividends can be automatically reinvested in additional shares. Finally, fund investors have easy access to their money and can buy or sell their shares in varying amounts.  Many funds even offer a checkwriting option as well as telephone redemptions. The potential disadvantages?  A bond fund lacks the individual bond’s fixed maturity date and yield.  The absence of a fixed maturity date means there is no point at which investors are assured of getting back the entire principal they’ve invested.  Consequently, depending on market conditions, they may have to sell their shares at a price that’s higher or lower than their purchase price.  Interest income, too, is variable. Despite the fact that substantially all of the interest the portfolio earns is distributed, the actual amount changes over time due to the wide mix of bonds that generate those earnings. The Impact of Interest Rates Generally, bond values and interest rates have an inverse relationship.  When interest rates rise, the price of already issued bonds generally decreases.  The reverse is also true – when interest rates fall, the price of an already issued bond generally rises.  Why?  The bond market, like all other financial markets, is competitive.  In a rising interest rate environment, bonds with lower rates become less attractive.  To compensate for that fact, they carry a lower price. Typically, longer-term bonds are more sensitive to interest rates, resulting in wider price swings.  Note, though, that because of a fund’s diversification, its share price may fluctuate less than the prices of individual bonds with the same maturity. Using Bond Funds in Your Portfolio When might a bond fund be a good choice for your portfolio?  It’s important to look at the composition of your total investment mix as well as how a bond fund can help you meet a specific investment need. Bonds vs. Other Asset Classes Bonds have generally underperformed stocks over the last 20 years, while staying ahead of CDs.  Keep in mind, however, that the price movements of bonds have been, on average, less volatile than those of stocks.  Because of their lower volatility and the fact that they frequently respond to economic cycles differently than stocks, bonds can help to diversify a portfolio of stock holdings. In fact, to manage risk most effectively, investors may want to consider diversifying across all three of the major asset classes—stocks, bonds and cash reserves (which include short-term CDs and money market funds)—as well as within each of these categories.  The question of which asset type predominates is dependent on an individual’s goals, time frame and risk tolerance. The need for income, shorter time horizons and a lower tolerance for risk all usually point to a portfolio consisting primarily of income-producing investments, which may include bond funds.  Aggressive growth objectives, longer time frames and a higher risk tolerance may indicate a stock-dominant mix.  However, before you make any investment decision, we recommend that you discuss your personal needs and goals with your financial advisor. A Final Consideration Choosing a bond fund can be a challenging task.  As you review this information, you’ll begin to sort through the criteria that’s particularly relevant to your own circumstances.  Your goals, time frame and risk tolerance are important. In the final analysis, your best source of information and assistance may be a financial advisor.  A professional can help you evaluate your choices in light of your total financial picture, which is the best way to make any investment decision. Get Expert Support Your investment advisor can help you develop an asset allocation plan that contains a percentage in bond funds, if appropriate for your situtation. If you are seeking a professional financial advisor, call CPIC at 415-989-1915.