Mutual fund investors looking to build a diversified portfolio should consider government and corporate bonds as part of their investment strategy. That’s where bond funds come into play.
A bond fund invests primarily in government, municipal, corporate or convertible bonds as well as other fixed-income instruments like mortgage-backed securities. The stated goal of most bond funds is to provide a stable monthly income for investors.
Bond funds are attractive because they can be tied to retirement accounts and can be used to hedge against market uncertainty. Since most portfolios have exposure to stocks, government and corporate bonds provide more stable investment vehicles. Although they often return less than equities, they provide “guaranteed” interest payments while preserving your capital until the maturity date. It’s also not uncommon for a bond’s interest payments to be higher than the dividend payouts of leading companies.
However, it is interesting to note that bond funds can be divided along several dimensions, including credit quality, maturity profile, dividend yield, geographic location, and the type of issuer. Let us see the different types of bonds in details.
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Investment Grade
Bond funds are often classified as being “investment grade” or not, depending on how well they’ve been rated by a third-party credit rating agency. Bonds that have been rated investment grade offer the highest credit quality, meaning your capital and interest payments are more likely to be preserved.
Debt instruments that fall under the investment grade bucket can include government bond funds like U.S. Treasuries, inflation-protected funds like Treasury Inflation-Protected Securities, mortgage-backed funds like those issued by Fannie Mae or a major bank, and corporate bond funds. Investment-grade bond funds have primary exposure to these types of assets. Vanguard Intermediate-Term Investment-Grade Fund Investor Shares (VFICX) and Vanguard Short Term Inflation-Protected Securities Index Fund (VTIPX) are good examples of investment-grade bond funds.
High Yield
Fund managers often invest in high-yielding bond funds to generate better returns for their investors. But there’s a caveat: high-yield funds usually have lower credit-quality securities – in other words, they’re inherently riskier. A common example is high-yield bank loan funds that invest primarily in floating rate loans issued by non-investment grade companies.
Examples of high-yield bond funds include the Nuveen High Yield Municipal Bond Fund (NHMRX) and the Invesco High Yield Municipal Fund (ACTHX).
Maturity
Bond funds can also be broken down by maturity date for the repayment of the principal. In the case of government bonds, maturity dates can range from four weeks to up to 30 years or longer.
It’s important to note that fund managers rarely hold bonds until maturity due to market conditions. For example, it’s not necessary to hold a bond fund with exposure to 10-year U.S. Treasuries for the full ten years. The fund can be sold long before the maturity date, provided there’s a buyer.
Click here to learn about the characteristics of bond funds.
Type of Holding
Bond funds can be further broken down by type of holdings. For example, multisector funds invest in many kinds of taxable bonds. That means the portfolio varies along with several criteria, including credit quality, average maturity, and average maturity. These funds can include a mix of corporate, government and high-yield bonds with various allocations.
Examples of multisector funds include the PIMCO Income Fund (PIMIX) and the Fidelity Advisor Strategic Income Fund (FSIAX).
Municipal
Municipal bond funds invest in securities that are backed by projects in specific states, municipalities or counties. They’re attractive for investors in higher tax brackets because they’re typically exempt from paying federal taxes. Keep in mind that municipal bond funds often generate lower yields than other debt instruments.
Examples of municipal bond funds include the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) and the American Fund Tax-Exempt Bond Fund (AFTEX).
International
As the name implies, international bond funds are taxable bonds issued by foreign governments and corporations. They provide the same benefits as other international investments – namely, diversifying away from a single market. This comes at the expense of slightly more risk as foreign governments and corporations may not be considered investment grade or have the same reputation as the United States.
Examples of international bond funds include the the Vanguard Total International Bond Index Fund (VTIBX).
Don’t forget to check out all funds from Vanguard here.
The Bottom Line
For mutual fund investors, bond funds are an effective way to diversify and create a well-balanced portfolio. Like other investment vehicles, bond funds must be approached with your stated investment goals and time horizon in mind.
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