When conducting your mutual fund analysis, many websites and tools take it for granted that you are aware of the different types of mutual funds available. Here is a primer on bond mutual funds to help you with your mutual fund research. We’ve kept it brief so that you can read this in between watching all the World Cup soccer action!
Types of mutual funds
There are three main types of mutual funds: stock funds, bond and income funds (including money market funds), and balanced funds – each classified according to the types of assets they invest in. Bond and balanced funds are generally typically less risky than stock funds, but will also generally produce lower returns. If protecting the value of your investment is important to you, with potential returns being secondary, then a bond fund may be the type of fund for you.
Types of bond funds
Bond funds invest in bonds, which are in essence interest-producing debt securities, classified according to the type of institution issuing them (such as a government or government agency, state or municipality, or corporation). Different categories of bond funds have differing levels of potential risk and return. Government bond funds are the least risky, but pay relatively low returns compared to riskier corporate and diversified bond funds.Here are the main categories of bond funds:
- Government or Treasury bonds are composed primarily of Treasury securities (government debt). The risk associated with government bonds depends on the stability of the country issuing them. Bonds issued by stable countries, such as the U.S. or the UK, are very highly rated, while bonds issued by economically emerging nations are typically considered more risky. Interest on U.S. Treasury bonds is typically exempt from state and local income tax.
- Government-insured mortgage-backed bonds are made up of home mortgages insured by Fannie Mae and Freddie Mac, which are government-sponsored enterprises. As a result, these bonds are generally considered to be low-risk.
- Municipal bonds issued by state and local governments and agencies are attractive to investors in upper tax brackets, since the interest is exempt from federal income tax. These funds may buy only bonds issued within a specific state, or they may invest regionally or nationally. It can be advantageous to invest a fund focusing on municipal bonds in the state where you live, since the interest is likely to be exempt from state and local tax as well.
- Corporate bonds are issued by companies wanting to raise capital and are guaranteed by the issuing company. The risk lies in the company’s ability to continue paying interest and return the investor’s principal at maturity. The bonds of a larger established company with a strong balance sheet are generally less risky (but may also pay less) than those of a struggling business.
- A diversified bond fund invests in a range of bond types including government, municipal, and corporate.
Bond funds are not risk free
Its important to understand that bonds aren’t risk free. In conducting your mutual fund analysis, you should know that rising interest rates can impact the value of your bond holding. Interest rates are currently hovering at their lowest levels in decades, so you should be aware that just as bond prices go up when yields go down, the prices of bonds will generally drop as yields—interest rates—go up. Bonds with a longer maturity are impacted more by an upward increase in interest rates than shorter term bonds. A ten year bond will usually lose more of its value if rates go up than a two year bond.
Which bond funds to invest in depends on many factors, including the State you live in, as well as your overall objectives and asset allocation. This is something we’ll explore further in future posts.
