Understanding Bond Funds

By: AARP Education & Outreach | Source: AARP.org | March 20, 2005

Bonds and bond funds loan money to corporations and government agencies. When you invest in a bond fund, you are loaning money in order to receive regular interest payments until the borrower has repaid the loan (or you've sold your shares). Bond funds are a good choice for earning a somewhat predictable amount of income.

In times of falling interest rates, a bond fund could increase in value, growing your money through capital appreciation. The opposite is also true; in times of rising interest rates, the bonds in your fund may lose value and cause you to lose money, even while you're earning income from interest.

Types of Bond Funds

Bond funds come in many different stripes. They can invest in U.S. or foreign bonds, corporate or government bonds, and risky or safe bonds. One common grouping of bond funds is based on the borrower:

• Corporate bonds: a corporation is the borrower
• Government bonds: the national government or its agency is the borrower
• Municipal bonds: a state or local goverment or its agency is the borrower

Another common grouping is based on the average length of the bonds:

• Short-term bond funds: bonds typically maturing in less than five years
• Intermediate bond funds: bonds typically maturing in five to 10 years
• Long-term bond funds: bonds typically maturing in 10 to 30 years

Generally, the longer the average maturity of the bonds in a fund is, the higher the fund's overall yield is. That's because loans for longer periods tend to be made at higher interest rates.

Ups and Downs

Share prices of bond funds reflect the value of the fund's underlying bonds. If interest rates drop, the fund's share price will tend to rise becaude the bonds in the fund will appreciate in value. If rates rise, the share prices will usually fall.

Yield is the percentage you're earning on your investment. It will differ depending on when you invest. For example, if the bond fund is earning $1 a share annually, and you paid $10 a share, you would have a yield of 10 percent. But if you paid $9 a share, you would have a yield of 11 percent.

A fund's yield, or earnings, will differ from your total return. If the price drops, the loss in value of your investment will reduce your overall return (called total return). If you sell your fund shares while the price is down, you could actually lose money even if you have earned some income.

Take Action

• Use Morningstar tools to find high performing, low-fee bond funds.
• AARP's Money Matters Tip Sheet on Investing in Bonds has more information and action steps.