A debt fund or a bond fund is a pool of investments, usually a mutual fund or an exchange-traded fund, that invests in fixed-income securities. The fixed-income securities include government bonds, corporate bonds, money market instruments, junk bonds, etc.
An example of a bond fund is the Vanguard Total Bond Market Index Fund, which holds more than 5,000 U.S. investment-grade bonds, including U.S. Treasuries and mortgage-backed securities of short, intermediate, and long-term maturities.
Bond funds, or debt funds, are investment pools of fixed-income securities. There are broadly five different types of bond funds – investment-grade, high-yield, municipal, international and global, and multisector bond funds.
The advantages of bond funds include the ability to diversify an investor’s portfolio, professional management of the portfolio, and a regular stream of income that these provide.
The disadvantages of bond funds include higher management fees, the uncertainty created with tax bills, and exposure to interest rate changes.
Types of Bond Funds
There are five broad categories of bond funds:
1. Investment-Grade Bond Funds
As the name suggests, these funds comprise investment-grade securities, which include bonds that are rated higher than BBB- (Standard &Poor’s rating criteria). There are four types of funds that fall under this broad category:
Government Bond Fund – Invests in bonds issued by the U.S. government like Treasury notes and bills, as well as mortgage-backed securities backed by the government. Since there is little default risk on these types of bonds, the yield offered is low.
Corporate Bond Fund – Invests in higher-quality corporate bonds. The bond fund offers a higher yield than a government bond fund because of the higher relative risk of investing in corporate bonds.
Inflation-Protected Bond Fund – Invests in Treasury Inflation-Protected Securities (TIPS) that are tied to the U.S. inflation rate, which is measured by the Consumer Price Index. The funds are a good hedge against inflation since their NAV goes up when inflation goes up.
Mortgage-Backed Bond Fund – Invests in securities that are backed by pools of mortgages. In a mortgage-backed security, the mortgages are securitized/packaged together by government-sponsored enterprises (GSEs) or investment banks and sold to investors as a security. This type of fund invests in these securities and offers a higher yield than government bond funds due to more risk carried by the securities that encompass it.
2. High-Yield Bond Funds
High-yield bond funds invest in securities that offer a higher return than investment-grade bonds. One of the types of securities is a junk bond (rated below BBB- as per the Standard and Poor’s criteria).
Another type of security is a floating-rate loan or leveraged loan that is issued by non-investment grade companies. These loans have a coupon rate that is floating above a common benchmark rate, such as the London Interbank Offered Rate (LIBOR).
In other words, they offer a rate that is equal to LIBOR+ a stated interest margin. The caveat of this type of fund is that securities have a higher default risk than investment-grade securities. However, since the fund invests in a broad range of junk bonds, one of the bonds getting default will not significantly impact your portfolio.
3. Municipal Bond Funds
Municipal bond funds invest in bonds issued by state and local governments. These types of bond funds are lucrative for people in higher income tax brackets since the bonds are free from federal taxes and state and local taxes if the municipal bond is issued in the investor’s home state.
However, when the fund manager sells the municipal bonds in the fund, it can generate a capital gain on which the investor might owe taxes (both federal and state taxes). These types of funds offer lower yields than corporate bonds since they come with a lower default risk, and the interest payments are tax-free.
4. International and Global Bonds
An international bond fund invests in bonds issued by foreign governments and corporations, while a global bond fund invests in bonds that are issued simultaneously in various regions around the world (Asia, Europe, the U.S.).
International bond funds give an investor exposure to securities issued by different sovereign nations and corporations and help them reduce the interest rate and economic risk.
5. Multisector Bond Funds
Multisector bond funds invest in a range of taxable bonds, including U.S. Treasuries, corporate bonds, high-yield bonds, etc. Such a type of fund provides the highest degree of diversification to an investor.
The portfolio allocation to the different bonds should be noted, as some funds may have more money allocated to high-yield bonds than U.S. Treasuries. Consequently, the return on the funds may also be higher.
Multisector bond funds also tend to focus on bonds based on the time horizon. For example, some of the funds may focus on shorter-maturity bonds, thus making the fund less exposed to interest rate changes.
Advantages of Bond Funds
1. Greater diversification
Bonds must be purchased in large denominations, and it would be harder for investors with smaller capital to achieve diversification if they invested in individual bonds. Bond funds can help an investor get access to a diversified portfolio of bonds as the funds trade at smaller share prices.
2. Professional management
Investing in fixed-income securities requires knowledge of the industry, and many people usually do not want to spend a lot of time researching and analyzing individual bonds. Through a bond fund, they can have their money actively managed by a portfolio manager who possesses the technical knowledge of the industry.
3. Monthly dividends
Most individual bonds pay interest semi-annually, while bond funds pay interest monthly. This allows an investor to get a regular monthly income and allows those payments to compound more quickly.
Disadvantages of Bond Funds
1. Management fees
Some bond funds are actively managed, and they charge a management fee, which may have a drain on the investor’s return. Even when compared to stock ETFs, bond ETFs usually have higher expense ratios.
2. Uncertainty with the tax bill
As mentioned before, when individual bonds in a portfolio are sold, it may create capital gain/loss. It is hard to predict these gains/losses for individual bonds, which makes it difficult to anticipate the tax consequences of investing in the bond fund.
3. Net Asset Value (NAV) fluctuation in the market
As interest rates change, the Net Asset Value (NAV) of the fund changes due to price changes of individual bonds in the portfolio. It is difficult to anticipate the NAV of the fund, and it makes bond funds less attractive to investors compared to individual bonds.