What is a Bond Mutual Fund?June 6th, 2012 by David Waring
Bond mutual funds pool the money of many investors into one large fund. This offers investors the benefits of diversification and professional management, which are often not available to individual investors buying bonds on their own.
If you have done any investing, you have probably heard names like Vanguard, Fidelity and PIMCO Funds. These are some of the larger companies that manage bond mutual funds. The largest mutual fund in the world is the PIMCO Total Return Bond Fund which has over $250 Billion under management.
How Bond Mutual Fund’s Work
When you invest in a mutual fund, you do so by buying shares in the fund. Unlike with a stock or Bond ETF you do not buy these shares on a stock exchange, but from the Mutual Fund Company itself. Mutual funds are also called “open ended funds” because there is no limit to the amount of new shares that the mutual fund company is allowed to issue. Investors can also enter and leave the fund at the end of each trading day. When a new or existing investor buys shares in the mutual fund, that money is then combined with all the other participants in the fund and used to purchase additional securities in line with the fund’s objectives. When an investor withdraws money, they do so by selling their shares back to the mutual fund company, which is also known as a redemption.
The share price of a bond mutual fund is also referred to as the Net Asset Value or NAV for short. A mutual fund’s NAV is calculated by taking the total value of the portfolio of investor money and dividing it by the number of shares outstanding. A fund with $100 Million under management and 1 Million shares outstanding would have a NAV of $100.
Most bond mutual fund advertising only focuses on the fund’s yield (you can learn more about the different types of bond fund yields here). However, this is only one of the three areas mutual fund investors can earn a return:
Distributions (Money Which Is Paid Out To Investors For Holding Shares)
- The interest that the fund earns on bonds in the portfolio is paid out to investors in the form of a dividend, which is generally distributed at the end of the month.
- If the bonds in the portfolio increase in value and are sold for a profit, the fund makes a capital gains distribution to its investors. This normally happens either once or twice a year. If you own a bond mutual fund when the capital gains distribution is made, then you are taxed on the entire amount of the distribution regardless of how long you have held the fund. This is why it is generally not a good idea to buy a bond mutual fund at the end of the year, or just before the capital gains distribution is made. For more on bond mutual fund taxes go here.
- The value of the fund increases and you sell the shares of the fund. A fund will increase in value when the bonds it holds increase in value. It should be noted, that you can have also have capital losses as the value of the shares may go down.
When you add the above three return components together and subtract expenses (excluding any sales fee or “load”) you get the fund’s “Total Return” which is the number that investors should focus on. You can learn more about bond fund total return here.
Types of Bond Mutual Funds
There are many different segments of the bond market which perform differently based on the type of bonds they invest in, and what is happening with interest rates and the economy. The 3 Main categories of bond mutual funds are:
- US Government Bond Funds – Invest only Treasury Bonds which is debt issued by the US Government and its agencies.
- Corporate Bond Funds – Invest primarily in investment grade corporate bonds.
- Municipal Bond Funds – invest only in municipal bonds, which is debt issued by municipalities such as cities and states.
Each of these groups also have bond mutual funds which focus on specific bond maturities such as short term, intermediate term, or long term bonds. You can learn more about the different types of bond mutual funds here.
Active vs. Passive Bond Mutual Funds
Passively managed funds (also referred to as “index funds”) are designed to track a benchmark index, such as the Barclays Capital Aggregate Bond Index, an index which tracks the performance of the entire investment grade bond market. They are called passively managed because the fund buys or sells bonds only to make sure it continues to track the index, and never to express a market view.
Actively managed funds employ professional portfolio managers whose job it is to take positions based on where they think the market is headed, and to outperform a specific benchmark. An investor who is new to the market might think that actively managed bond mutual funds have the best returns. However, many studies have shown that the majority of actively managed mutual funds do not beat their benchmark index on a regular basis. For more on this read our articles “Active vs. Passive Bond Funds” and “Are Actively Managed Funds Worth the Cost?“.
Bond Mutual Fund Fees
The diversification and professional management benefits of Bond Mutual Funds come with a price. The expenses incurred when investing in a bond mutual fund can be small or large depending on the fund, its setup and the share class you are investing in. The three main types of fees are loads, commissions, and fund expenses which are passed along to investors. You can learn more about the different types and how to minimize fees in our article on understanding and minimizing bond mutual fund fees.
To see our bond fund ratings and top choices for investors visit the LB Ratings page here.