Bond Funds - What Should I Know About Bond Mutual Funds?

Summary: This article discusses the common features of bond funds - capital requirements, upsides, downsides and some of the complexities of exchange traded bond funds.

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Bond instruments aren't the easiest to understand or trade.

They have more predictable characteristics — owing to their fixed maturity (principal repayment date) and coupon (interest rate). But those predictions are fairly technical and sometimes even difficult to follow for the beginner.

The capital requirements for bonds are also higher than traditional instruments. They're usually issued in $1000 increments, with a $5000 minimum investment requirement commonplace.

But, part of the fun of bond investing is overthrowing tradition. This is where bonds mutual funds come in.

Like other funds, a bonds fund operates by pooling investor money then diversifying that investment by buying and selling different instruments, attempting to maximize return while minimizing risk.

Since exchange traded bond funds are managed by investment professionals, so the theory goes, they have a better chance of achieving those goals than individual investors with limited time and training at picking specific bonds.

For that service, of course, the investor (usually) pays a fee. Different funds have differing payment options — front-end loads (which charge a commission when shares are purchased), back-end loads (which charge when selling out, but often carry an annual fee as well), and no-loads (no commission).

Opinions differ over the pros and cons of the commission options, but a comment or two here will suffice. No-load bond funds carry no commission because the shares are offered directly by an investment company. Therefore, no adviser continually monitors the investment. Whether the adviser's fee is more than made up for by the added advice is a matter of some controversy. But then, in investing, what isn't?

The investors are said to be 'buying shares' because, legally/technically, most funds operate by offering shares in the bond fund company (also called 'the fund'), which then uses the money to buy the instruments making up 'the fund' (the basket of instruments in the portfolio). Confusing enough?

The downside of bond fund investing isn't just the management fees paid, however. Unlike the bonds they buy, the investment isn't guaranteed. Granted, no bond is truly guaranteed, but highly rated corporates (AA or above) or U.S. Treasuries are about as good a guarantee as one gets in life.

With a fund, the risk is on the investor that the fund may make money or lose money. And, according to some, nine out of ten fund managers lose money for their clients. But, ah, that tenth!

There are, even so, several advantages to fund investing.

As stated, most investors don't have the time or expertise to carefully research or track individual bonds.

Not surprisingly, there exists a bewildering variety of bond funds — those that focus on primarily governments (of which the U.S. Treasury alone has over 30 choices), corporates (thousands), foreign, asset-backed and dozens other categories or mixtures thereof.

That problem can be solved by investing in well-known, low-risk bonds, but they carry a correspondingly low yield (return over time).

For those willing to endure more risk, there are still advantages. Bond mutual fund managers use an array of hedging techniques — including buying indexed funds, such as those that adjust automatically for inflation or fluctuate according to bond indexes.

They're also paid to be aware of any new instruments offered and trade without charging individual trading fees for getting in and out. Those trading fees, even at $10 a pop can add up to an annual management fee pretty quickly for investors who trade often. Funds allow investors to input lower amounts, often much lower than is required to purchase the underlying bonds. Now for the kicker. One of those types of funds, requires the investor to input as little as $25.

MBSs (Mortgage-Backed Securities, once esoteric, now common) FITRs (Fixed-Income Exchange Traded Funds, recently the latest rage, now becoming common) and even more creative methods of packaging debt for investors come and go with blinding speed.

A good bond fund manager will know how to take advantage of those complex and beautiful creatures. The only thing you have to do is to find that tenth one.