If you're like many people, you may be interested in bonds - specifically, bond-based mutual funds - as a "refuge'' from the volatility of the stock market. And it is true that, in general, bond funds will fluctuate less in value than stock-based mutual funds. However, don't expect bond funds to remain totally stable - they won't. But that doesn't mean they can't be valuable additions to your portfolio. They can - if you know what to expect.
A bond fund, as the name suggests, is made up of many individual bonds. But a bond fund differs from single bonds in at least two important ways:
· Income stream may fluctuate - An individual bond is traditionally issued with a fixed interest - or "coupon'' - rate that will not change as long as you own the bond. Consequently, you'll always receive the same interest payments. Within a bond fund, though, single bonds are constantly maturing or being "called'' (paid off by their issuers). To replace these bonds, a bond fund's managers may have to reinvest at lower rates, which could reduce your income from the fund.
· Original investment amount not guaranteed - When you buy an "investment-grade'' bond - a bond that receives one of the highest grades from a rating agency - you can be reasonably sure that, if you hold the bond to maturity, you can expect the face value to be returned. But a bond fund never "matures'' - you simply hold it until you decide to sell it. And when you sell your bond fund, it may be worth more or less than what you originally paid for it.
Clearly, a bond fund does not offer the type of stability you might expect from an individual bond. And yet, by investing in a bond fund, you can gain some key advantages. For one thing, bond funds invest in dozens of individual bonds - from various issuers and with varying maturities. In short, these funds offer you a degree of diversification that might be hard to attain - and afford - if you tried to buy a collection of individual bonds.
Furthermore, when you invest in bond funds, you get something else you can't get from individual bonds: professional management. When making "buy'' and "sell'' decisions, portfolio managers evaluate the universe of bonds to find the ones that can make the greatest contributions to their fund. In short, for a relatively modest investment, you get shares of a bond fund - and you also "hire'' professional money managers with years of training and experience.
Finally, bond funds offer a feature that can help you speed your progress toward your long-term goals: reinvestment of interest payments. When you buy shares of a bond fund, you can choose to reinvest your interest payments into the same fund, or into another one. This is an easy way to build up your holdings. (You can also choose to reinvest interest payments from individual bonds into mutual funds.)
If you're just looking for a way to avoid the ups and downs of stocks, bond funds are not the answer. But if you want to help diversify your overall portfolio, and provide yourself with an additional source of income, then you may want to explore high-quality bond funds. Under the right circumstances, they may be a good fit for you.