Do You Understand Bond Funds?

A lot of people have trouble understanding how bond funds work and consequently when is a good time to buy them. So here are some thoughts and information gathered over many years of successfully investing in these sometimes underappreciated assets.

What You See May NOT Be What You Get

Just as with stock funds, there are three factors that will determine how an investment in a bond fund will do, none of which are known precisely at the time you buy them:

1) Will the price (that is, the net asset value - NAV) go up or down as compared to when you purchased shares?

2) Will the fund distribute any dividends?

3) Will the fund distribute any capital gains resulting from changes within the portfolio by the fund manager?

In many cases, but not all, people who invest in bond funds do so primarily in order to receive these funds' dividends without much regard to the two other factors. This is because such dividend payments are the most visible aspect governing a bond fund's return and usually are a lot more generous than the interest rates available with a standard bank account or even through money market accounts. However, by focusing solely on dividend payments, these investors often lose sight of the profit or loss possibilities from changes in the fund's NAV or from capital gains achieved by trading of securities by the fund manager, as is almost always something that is of the upmost concern for stock fund investors, and especially so for those in actively managed funds.

"But I Thought Bonds Deliver a Fixed Level of Return"

A bond fund (sometimes, but probably inappropriately called a "fixed" income investment) is made up of a number of individual bonds that have been purchased by the fund manager. Although each of these individual bonds have a fixed coupon (ie, a level "interest" payment), the yield on each bond is recalculated on a daily basis and will vary depending upon ever-changing market interest rates.

If prevailing market interest rates go up, so do the yields, while at the same time, bond fund NAVs go down. The yield you receive as a bond fund shareholder, therefore, changes daily with movements in overall interest rates. It represents roughly the average of the yield of all the bonds in the portfolio. So, in a climate of rising rates, your bond fund holdings will suffer from a decline in the NAV although this will be offset somewhat by the higher yield you will begin receiving in the future.

Since your total return for a particular fund is determined not just by dividend yield but by how much its NAV goes up or down and/or any capital gains within the portfolio, it follows that it makes the most sense to buy bond funds when the NAV is relatively low. If the NAV is low, there is a chance it may go higher resulting in a capital gain when you sell it. Also when the NAV is low, this has the added advantage that the yield available will be relatively high since price and yield are inversely related. Thus, if you can buy a bond fund when the NAV is low, you get a relatively higher yield than you would have gotten if you bought the same fund when its yield was lower. And getting a higher yield for owning the same investment is obviously a plus!

So Where Does This Put Us Today?

Is now a good time to buy a bond fund? Or, to rephrase the question in terms of the above, are bond prices relatively low now and consequently yields relatively high? And even if the answer to this question is yes, the astute investor needs to also ask: Do I expect bond prices to go even lower (and yields even higher)? Since there are many different kinds of bond funds, each of which perform differently depending on the economic backdrop, the answer may differ depending upon the type of bond fund you are considering.

Editor's Note: We discuss the outlook for various types of bond funds in our free email newsletters.

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