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 too little appreciated assets.
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 recognize any capital gains resulting from profitable sales 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 can be 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, which are usually a function of interest rate movements. There may also be or gains or losses achieved by the trading of securities by the fund manager, as is almost always an important concern for stock fund investors in actively managed funds.
A bond fund (sometimes 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 interest payment, the yield on each bond is recalculated on a daily basis and will vary depending upon ever-changing market interest rates.
If interest rates go up, usually so do the yields, while at the same time, bond fund NAV's 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 typically 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!
Because interest rates dropped from where they were in the 80s and 90s, NAVs have been at historically high levels in the last few years. This would seem to suggest it may not be a particularly good time to buy most bond funds. To see my recommendations as to how much of a portfolio should be in bond funds right now, and which particular types of bond funds seem to offer the best prospects, request my free bond and stock fund recommendations at my home page.