What is a bond fund?
A bond is a financial instrument that represents a loan made by a government or organisation. When a government or business wishes to raise capital for any projects they may have, one method of generating money is through the issuing of bonds.
So, say you purchased a treasury bond from the UK government. You would essentially be “loaning” the government money to use on public works. You will typically be paid regular interest from this bond, called the coupon, and given a fixed date that the bond expires.
When this bond expires, you will typically be paid back the amount you invested. This is how bond traders earn a profit – they accrue interest on top of the original investment.
Meanwhile, a fund works by pooling money from multiple retail investors and then trading different financial instruments. A fund is typically overseen by a fund manager, a professional who will make decisions on the fund’s underlying holdings.
Since a fund provider will invest in a wide variety of different assets, you are essentially gaining wide diversification from a single investment, as the fund is exposed to a number of different assets.
So, when you combine the two, you get a bond fund.
As the name suggests, a bond fund is simply a pooled investment fund that takes your money and invests it in a number of different bonds. These work similarly to equity funds, though instead of investing in companies listed on the stock market, they are holding bonds bought on bond markets.
You can either speculate on bond funds by buying a stake in them and then selling them at a later date for a profit when the price increases. Alternatively, you can hold on to them for a long period of time and rely on a fixed income from the fund.
These regular payments are called “dividends”, and income paid from them typically depends on the performance of the fund. This can make them useful additions to income portfolios.
Do bond funds make good investments?
First off, I can’t stress enough how important diversification is for your portfolio. You ideally want to spread the risk of your investments across a number of different areas and sectors; this way, should the worst happen, and the stock market takes a downturn, your portfolio won’t be as negatively affected.
One way to potentially diversify your portfolio is through bond funds. In fact, the price of bonds tends to move inversely to interest rates – when interest rates rise, bond prices tend to fall.
Since central banks – in the UK’s case the Bank of England – tend to increase interest rates during periods of rising inflation, this means that the price of bonds tends to drop.
So, rapid interest rate movements bring extra risk when it comes to investing in bond funds – a phenomenon known as “interest rate risk”.
While bonds typically offer lower returns when compared to stocks and shares on the equity markets, they are typically lower risk. This is because you are given an expiry date, and you know exactly when you will receive your investment back.
Also, the stability of a bond usually relies on the stability of the issuing company or government. For example, if you invested in US government bonds, there is a fairly low chance these will default as the US government is considered relatively stable.
Of course, while all of this should give you a rough idea of whether bond funds are an attractive investment, there are many different types on offer. Some may better suit you than others, so keep reading to find out about the different types of bond funds you can invest in today.
What are the different types of bond funds?
There have been several times in this guide that I’ve mentioned the different types of bonds that a fund may invest in. Here, you can read about the different types of bonds listed on the market, and the benefits and downsides that each brings.
Corporate bond funds
As the name suggests, a corporate bond is a loan issued by a company to raise capital for any projects they may have planned. So, a corporate bond fund is simply a fund that invests in these corporate bonds.
A corporate bond fund tends to focus on higher-quality, investment-grade bonds. Compared to higher yield bonds, corporate bonds tend to have a lower risk of defaulting as the companies are more likely to be able to pay off their debts. However, a result of this lower risk is that they tend to offer lower yields.
High-yield bond funds
Another type of bond fund you can invest in is a high-yield bond fund. These invest in bonds that offer a higher annual yield, in compensation for the additional risk you take on. These bonds are typically issued by companies that may be less likely to be able to pay off their debts, meaning there’s a higher chance of the bond defaulting.
Even though these types of bond funds may sound promising, it’s worth taking your appetite for risk into account. If you don’t think you could handle the extra pressures of high-risk investments, you should avoid them.
Government bond funds
Government bonds are simply bonds issued by a government to raise money for any projects they may have.
In the UK and several other Commonwealth nations, government bonds are commonly referred to as gilts. So, as you can imagine, a government bond fund is a pooled investment that will invest in government bonds.
Since governments tend to be more stable than corporations, you may find that gilt bond funds have lower default rates, but also lower potential yields, than corporate bonds. Though, it’s worth keeping in mind that bonds issued on emerging markets may have higher default risks since these governments are considered “less stable”.
Strategic bond funds
A strategic bond fund, meanwhile, is a fund that has the freedom to invest in a plethora of different instruments. For example, a strategic bond fund could invest in a mixture of government bonds, corporate bonds, and high-yield bonds.
Strategic bond funds tend to have different objectives – some may be focused on high returns for their investors, while others may be more tailored towards sheltering their investors’ wealth.
Global bond funds
As the name suggests, a global bond fund invests in different types of bonds that are issued right across the globe. They will typically diversify their investments by purchasing bonds in currencies other than pound sterling, which gives them exposure to foreign currencies.
For example, a global bond fund may invest in both sterling- and dollar-denominated corporate bonds to hedge against both currencies. And, similarly to strategic bond funds, a global bond fund can invest in different forms of bonds, including government, corporate, and high-yield bonds.
Index-linked bond funds
Finally, an index-linked bond fund is a fund that invests in bonds, but also aims to move in line with rising costs as much as possible by paying coupons that have been adjusted for inflation.
These index-linked bond funds will track an inflation indicator, such as the Consumer Price Index (CPI), then pay investors the real yield plus any accrued inflation.
Since the price of bonds tends to move inversely to interest rates, and thus inflation, an index-linked bond fund could make a potentially strong investment during times of high inflation.
