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The Good and Bad of Bond Funds

Bond Funds

What Are Bond Funds?

Bond funds are types of mutual funds. These collective investments differ from other funds because they primarily concentrate their investments on bonds. In some cases, a bond fund is composed exclusively of bond investments. There are four main types of these funds.

• Government bonds — These funds mostly buy U.S. Treasury bonds. While they are popular for their safety, they are not very profitable because the yields are low. The low yields are caused by the safety of these investments.

• Municipal bonds — Funds that focus their investments in these bonds are often exempt from federal taxes.

• Corporate bonds — These funds carry a higher risk because their funds are insured by companies rather than governments.

• Mortgage bonds — Government loan agencies, such as Fannie Mae and Freddie Mac, issue such bonds.

Advantages and Disadvantages of Bond Funds

It may not seem apparent why a bond fund might seem superior to investing directly in bonds themselves. Some investors prefer these investment schemes for the management provided. This facet of a bond fund saves investors from having to do their own research.

Other investors appreciate the diversification, even though the differences between the yields of distinct bonds are much less than those found between stocks. The liquidity of these investments is what draws many investors back during troubled times in the market. They know that they can buy a bond fund and wait until trouble passes. Then it is easy to sell it and reinvest in stocks that are more active.

There are drawbacks to bond funds, especially when compared to individual bonds. Funds usually charge fees for purchases that are calculated using the total investment amounts. The yields with bond funds vary because they are spread across several different bonds rather than keyed in to one. Since fund managers change the nature of the investment over time, the net asset value of bond funds will change rather than remain at a guaranteed rate.

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Is It Too Late to Buy Bond Funds?

How Bond Funds Reached Current Elevated Levels

Bond FundsBond Funds, including mutual funds and Exchange Traded Funds (ETFs), that invest in a wide variety of bonds (both government and corporate) have done well since the financial crisis of 2008 and 2009.  The reason why Bond Funds have done well in recent years is because investors who were spooked by the sharp drop in the stock market in 2008 and 2009 sought out safer places to invest their money.  Not wanting to put their cash in low yielding bank savings accounts, investors piled into Bond Funds, which pushed the price of Bond Funds higher.

Many investors have done well over the past two to three years with the strategy of investing their money in Bond Funds, as their money has been earning a decent steady rate of return.  The weak economic recovery and reluctance of the Federal Reserve to raise interest rates has caused demand for bonds and Bond Funds to continue to be strong, which has supported the price of Bond Funds, as strong money flows have keep buy side pressure on Bond Funds.

While investors jumped into Bond Funds because they were looking for a safe haven during the 2008 and 2009 financial crisis, investment advisors recommend maintaining a 20% to 30% investment in highly rated bonds during all times to diversify one’s investments across multiple asset classes.

The Current Risk Associated With Buying Bond Funds

With bonds and Bond Funds currently at elevated levels due to the buying pressure over the past three years, the question must be asked whether buying Bond Funds is currently risky since in a normalized economy the bonds and Bond Funds should revert to their mean and fall in price.  Those who brought Bond Funds before or early on in the 2008 and 2009 financial crisis are sitting on good positions that have earned interest over time, and have little risk of losing money on the principal that they invested in Bond Funds.  However, those who are contemplating purchasing Bond Funds now, at their current elevated price levels, need to realize that there is a real risk that once the economy returns to normal, and growth rates and interest rates start to rise, the Bond Funds will fall in price, as buying pressure eases and holders of bonds and Bond Funds sell.  This will put their investment capital at a risk of a slight loss as the value of the Bond Funds they hold decrease.

The potential for a slight loss from buying Bond Funds now may seem acceptable to some investors since the economy currently appears to be slowing, and another recession may be on our doorstep.  Another recession would ensure that Bond Funds will maintain their elevated levels for a prolonged period of time, allowing the buyer of Bond Funds to recoup some of their initial investment via interest payments on the bonds held by the Bond Funds.

It should be noted that due to concerns about defaults in municipal bonds, Bond Funds that invest in municipal bonds are actually at depressed levels, so the risk of buying these funds at elevated levels is not a factor.  However, funds invested in municipal bonds could fall substantially if defaults in municipal bonds occur on a widespread scale due to another recession causing cash flow problems for state and local governments.  For more information about municipal bonds, see:  Municipal Bonds Offer a Safe Way to Earn Tax Free Income.

There are many different Bond Funds that invest in a wide variety of bonds with various bond ratings and maturity dates.  Although, the risk associated with buying Bond Funds now and incurring a loss of principal when the economy recovers is something to consider, Bond Funds are worth considering for the relative safe and secure returns that they provide.

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