3 Things to Know About Bond Funds
bonds funds can have risk. Find out which funds are riskier than others.
Here are three things to know about your bond funds:
1. Think total return not just yield. The overall returns for a bond fund come from the yields on the underlying bonds held by the fund as well as gains and losses on the underlying bonds held by the fund. This includes both realized and unrealized gains. Although the longer-term return on a bond mutual fund should equate to its yield, other factors will come into play that can cause fluctuations in the value of the fund in the short term.
Here are three things to know about your bond funds:
1. Think total return not just yield. The overall returns for a bond fund come from the yields on the underlying bonds held by the fund as well as gains and losses on the underlying bonds held by the fund. This includes both realized and unrealized gains. Although the longer-term return on a bond mutual fund should equate to its yield, other factors will come into play that can cause fluctuations in the value of the fund in the short term.
2. Duration is key to your fund’s sensitivity to interest rate fluctuations. Morningstar's definition of duration is, “a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond. A bond’s duration is expressed in years and is generally shorter than its maturity.
For example, PIMCO Total Return, the largest bond mutual fund has a duration of 5.37 years as of Dec. 31, 2013, according to Morningstar. This means that everything else being equal a 1 percent increase in interest rates would result in a 5.37 percent decline in the value of the fund’s underlying holdings. In reality, duration is a guide and other factors such as the fund’s yield would factor into the impact on the fund’s total return.
As a comparison, the Vanguard Long-Term Bond Index has a duration of 14.2 years, indicating a 14.2 percent decline in the portfolio, if interest rates were to increase by 1 percent.
3. Bond funds come in many styles. Make sure that you understand how your fund invests your money. There are numerous categories for bond funds including:
corporate bond
short-term bond
short-term government
ultra-short bond
intermediate bond
high-yield municipal bond
inflation-protected bond
world bond
nontraditional bond
long government bond
long-term bond
multisector bond
national short municipal bond
national intermediate municipal bond
national long municipal bond
various state specific municipal bond funds
World bond funds contain varying percentages of foreign bonds, which, besides interest rate and credit risk, can expose the fund holder to currency fluctuation risk, unless the fund hedges its currency bets.
investing in bond funds has been pretty easy. With interest rates at record low levels, meaningful returns in fixed-income may be hard to come by over the next few years.
