Buying Into A Bond Fund
Posted on November 15, 2007 in the Investing, Mutual Funds category
.In the first section of this article we looked at the different types of individual bonds and how an investor can purchase them. In this post we will look at how a bond mutual fund works and explain why an investor might choose a bond mutual fund rather than invest in individual bonds.
Bond funds versus individual bonds.
Like stock mutual funds, a bond fund pools money from many investors and uses the money to buy securities that meet the funds stated investment objectives and policies. The decisions to buy and sell individual bonds are made by a professional portfolio manager.
A bond fund offers the following important advantages to investors:
Regular Monthly Income:
A bond fund typically distributes all its interest income as a dividend distribution each month. Investors have the option of receiving these dividends in cash or to have them automatically reinvested into more shares. Individual bonds generally pay interest at six-month intervals, and those payments cannot automatically be reinvested
Lower investment amounts:
To buy an individual bond, an investor usually needs least $10,000. To buy a bond fund, all you need is the minimum initial investment for the fund, which is usually between $2,500 and $3,000. Bond funds have a huge advantage over individual bonds if you need to add some more money to your account. Most bond funds allow you to purchase additional shares for under $500, which you cannot do with individual bonds as they trade in $1,000 increments.
Professional Management:
Fund managers get paid to identify which securities to buy and sell as well as keep on top of news that could affect the bonds in their portfolio. Few individual investors have the time or expertise to track or investigate the thousands of bonds available in the financial markets.
Portfolio Diversification:
Because a bond fund owns many different bonds in its portfolio it offers its investors a measure of diversification. While this diversification doesn’t offer protection against trends in the overall bond market, it can help balance the poor performance of an individual bond by other bonds that are performing well.
Disadvantages to owning a bond fund
While the four reasons mentioned above make a pretty compelling case for buying bond funds instead of individual bonds I would be remiss if I did not point out the disadvantages of owning a bond fund.
1. Fluctuating monthly income:
Unlike a individual bond where you know exactly how much income you will receive every six months, the dividend income paid by a bond fluctuates depending on interest rates and whether the fund manager is buying or selling individual bonds.
2. No fixed maturity date:
If you buy a five year individual bond, you know that in five years you will receive the face amount of the bond. This is not the case with a bond fund. A mutual fund maintains an average “rolling” maturity by selling off aging bonds and buying newer ones. After five years, a 5-year bond fund will still have a 5-year average maturity.
3. Capital Gains: When a bond fund buys and sells bonds it is creating taxable capital gains for its shareholders even though the shareholder is just interested in the income produced by the fund.
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