Bond Based Mutual Funds—Section 8
Bond based mutual funds offer the same advantages of diversification and professional management as stock based funds. Bond funds are characterized by the types of bonds that they invest in, the credit worthiness of the issuer, the length of time until maturity and the country in which the bonds are issued.
The same factors that affect the risk return characteristics of individual bonds apply to bond funds. U.S. government bond funds provide the highest degree of safety but offer the lowest return. Investment grade corporate bond funds have a slightly higher level of risk but provide a little more in the way of return. Speculative bond funds have the highest returns but also the highest risk.
Bond funds can invest in bonds with short, intermediate or long term maturities. As is the case with individual bonds, all things being equal, the longer the maturities of the underlying bonds, the higher the yield and the more the fund will fluctuate in value due to changes in prevailing interest rates.
People saving for retirement invest in bond funds because they represent a relatively stable store of value. Income is usually a secondary consideration. Because of this, most people invest in either U.S. Government or Investment Grade Corporate Bond funds.
A practical advantage of bond funds is that they will accept small periodic deposits, typical of 401k contributions. They also provide immediate diversification because each fund invests in many different bond issues. You can easily ladder bond maturities by investing in short, intermediate and long term bond funds. This reduces price fluctuations resulting from changes in prevailing interest rates while increasing overall portfolio yield (see section 7).
While bond funds can be an important part of a retirement portfolio, they should only be used to provide the degree of safety required as determined by your risk tolerance. The reason is that the historical long term return on bonds has been much less than that of stocks. You need the higher return of stock based mutual funds to offset the effects of inflation and to provide for real investment growth.
Quiz - Section 8
1.The main advantages of bond based funds when compared to individual bonds are _____________. Select all that apply.
A) Immediate diversification
B) Professional Management
C) Small amounts can be invested
2.U.S. Government Bond Funds provide the __________ level of safety and the __________ return.
A) Highest, lowest
B) Lowest, highest
3. Bond funds should be used:
A) Exclusively because they are safer than stock funds
B) Not at all because their long term historical return has been less than stock funds.
C) Only to the extent required to provide the level of safety determined by your risk tolerance.
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