The Funds: Bonds
We have been discussing the world of equity funds. Now, let’s dive into bond funds and other types; and, to top it off, we will discover the best ways to invest in investment funds.
By now, the concept of bonds should sound familiar. They are debt instruments that provide you with a fixed, periodic income for a specified period of time. You lend money to an institution, you get rewarded for it (with periodic interest payments) and end up receiving the principal amount (money lent) at the end of the agreement. They are generally safer than stocks, and therefore they render lower returns. However, they aren’t riskless, there are certain innate risks that go with investing in bonds, which we will talk about in future sections.
Bond funds work exactly like equity funds. Remember the example we discussed in previous sections, where you and your friends pooled your investing money together and allocated it into renewable energy companies, creating a “simplified” equity fund. Now, imagine you and your friends decide to invest your pooled money in a diversified portfolio of bonds of different institutions and characteristics. It is easy to figure out what you would call this, a (simplified) bond fund.
Great Way to Diversify in Bonds
We believe that a great way to buy a diversified portfolio of bonds for you (as a retail investor) is through bond funds. Bond funds, as Equity Funds, are managed by professional portfolio managers who allocate the pooled capital to a set of bonds with certain characteristics that match the purpose of their fund. We say it is good for diversification purposes because, like equity funds, they allow you to get exposure to many different bond issues (of different characteristics) with a small amount of cash.
Types of Bond Funds
Government Bond Funds
These allow you to invest in a variety of government bond issues that vary in maturity and risk levels. The most popular major types are Short-Term, Mid-Term and Long-Term Government Bonds.
Municipal Bond Funds
These funds include bonds issued by state or local government entities, they tend to be a reliable source of income with little risk.
Investment-Grade Bond Funds
As we’ve seen in previous sections, private agencies grade bonds, and their issuers. Investment-grade bond funds focus on high-quality, low-risk bond issues that tend to yield lower returns but have very low risk.
High Yield Bond Funds
These funds are focused on generating higher returns for investors; but, as we know, these high returns come with more risk.
International Bond Funds
These funds focus on allocating great or all their capital into bond issues from outside the US. They offer exposure to different global markets and regions.
Pros of investing in bond funds
We’ve established that bond funds are overall a good way to diversify in the bond world for a retail investor, but let’s see exactly why:
- Very low capital needed
- Easier to diversify your portfolio
- Professionally managed for goal achievement
- You don’t have to deal with maturity dates
- Low cost of purchase (low expense ratios) compared to owning actual bonds
Cons of investing in bond funds
Basically, the cons of investing in bond funds are the same as the intrinsic risks of investing in bonds. Here are the most important ones:
- Interest rate risk
- Maturity risk
- Default risk
Let’s be real. If you are looking to allocate some of your capital to bonds (which we recommend to some extent), investing in bond funds is your best bet. However, we insist, you still have to do your research to find the best funds for you.
Now, we have a good idea of what equity and bond funds are and the main types available. But there are funds built for virtually any combination of assets possible. Balanced funds don’t just focus on equities, they allocate their capital to a combination of both stocks and bonds. A classic example is the 60/40 fund, which allocates 60% of its capital to equities and 40% to bonds.
These funds offer a high amount of diversification and are typically meant to reduce the risk of investing in stocks by including bonds into the picture. However, they can be a little too rigid, they are fixed at a certain allocation (a.k.a. 60/40) and more generalized asset classes (they don’t really let you dig deep into sub-classes), which may not be ideal for you as your goals and needs change with time.
Balanced portfolios are good but we believe that in order to optimize your portfolio, you’d be better off by investing in separate equity and bond funds. That way, you will be able to find more specific funds that could better target your needs and characteristics as an investor.
In the next section, we will see some of the tools we use to measure our investments’ performance.