What Is a Bond Fund? How It Works, Benefits, Taxes, and Types

What Is a Bond Fund?

A bond fund is a mutual fund or an exchange-traded fund (ETF) that buys and sells debt instruments like government and corporate bonds. The primary goal of a bond fund is to generate monthly income for investors.

For an investor, a bond fund is an alternative to buying individual bonds. The investor in a bond fund is buying shares in a fund that buys and sells many bonds. Typically, a bond fund manager buys and sells according to market conditions and rarely holds bonds until maturity.

Understanding Bond Funds

For many investors, a bond fund is a more efficient way of investing than buying individual bond securities. Unlike individual bond securities, bond funds do not have a maturity date for the repayment of principal, so the principal amount invested may fluctuate from time to time.

Investors in bond funds receive monthly payments that reflect the mix of all the bonds in the fund, which means that the interest income payment will vary monthly.

Types of Bond Funds

Most bond funds are comprised of a certain type of bond, such as corporate or government bonds.

They also focus on a time to maturity, such as short-term, intermediate-term, and long-term.

Investors can choose bond funds that buy only the highest-quality and safest bonds, such as U.S. government bonds or the bonds of blue-chip companies. High-quality bonds pay lower interest than riskier bonds.

Investors should note that U.S. government bonds are considered to be of the highest credit quality. Bond funds that specialize in U.S. Treasury securities, including Treasury inflation-protected securities (TIPS), are the safest but offer the lowest potential return.

Riskier Choices

Other funds invest in only riskier bonds—high-yield or junk bonds. Bond funds that invest in riskier bonds offer higher returns along with a higher risk of default by the bond issuer.

There are also bond funds that have a mix of the different types of bonds to create multi-asset class options.

The types of bond funds available include US government bond funds; municipal bond funds; corporate bond funds; mortgage-backed securities (MBS) funds; high-yield bond funds; emerging market bond funds, and global bond funds.

Bond Fund Benefits

Bond funds are an attractive option compared to buying individual bonds. They provide greater portfolio diversification than an individual investor could manage independently.

By investing in a bond fund, an investor need only pay the annual expense ratio that covers marketing, administrative, and professional management fees. The alternative is to purchase multiple bonds separately and deal with the transaction costs associated with each.

Since a fund usually invests in many bonds of varying maturities, the impact of any single bond’s performance is lessened.

Another benefit of a bond mutual fund is that it provides access to professional portfolio managers who have the expertise to research and analyze the creditworthiness of bond issuers and market conditions before buying into or selling out of the fund.

For example, a fund manager may replace bonds when the issuer's credit is downgraded or when the issuer "calls," or pays off the bond, before its maturity date.

Special Considerations

Bond funds can be sold at any time for their current market net asset value (NAV), which may result in a capital gain or loss. Individual bonds can be harder to unload.

From a tax perspective, some investors in higher tax brackets may find that they have a higher after-tax yield from a tax-free municipal bond fund investment rather than a taxable bond fund investment.

Due to the inverse relationship between interest rates and bond prices, a long-term bond carries greater interest rate risk than a short-term bond. Therefore, the NAV of bond funds with longer-term maturities will be impacted greatly by changes in interest rates. This, in turn, will affect how much interest income the fund can distribute to its participants monthly.

Bond ETFs

Bond ETFs have been around for less time than bond mutual funds, with iShares launching the first bond ETF fund in 2002. Most of these offerings seek to replicate various bond indices, although a growing number of actively managed products are also available.

ETFs often have lower fees than their mutual fund counterparts. Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of a day's trading.

Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company.

When the investor wishes to sell, ETFs must be traded on the open market. The fund company will not purchase the shares, as is done for open-ended mutual funds.

The Bottom Line

Bond ETFs and bond mutual funds are an alternative to individual bond-picking for the investor interested in a steady stream of income.

Like bonds, bond funds are generally a choice for the conservative investor. As with any investment, a little more risk has the potential for a relatively larger return.