Bond funds: Know the types before you choose

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With funds, you can invest in hundreds or thousands of bonds.

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Even if you’re at the very beginning of your investing journey, you’ve probably heard some form of the diversification argument. In particular, you may have heard about the importance of bonds and other fixed-income securities as a key part of diversifying your investment portfolio to reduce risk.

You may have also heard that you can invest in funds—including mutual funds and/or exchange-traded funds (ETFs)—to reduce the risk of a single security wreaking havoc on your portfolio. Funds invest in hundreds or even thousands of individual securities.

Just as there are many different types of fixed-income investments, there are many types of bond funds (aka fixed-income funds), and they can all play different roles in your overall investment planning.

As you build your bond fund portfolio, decide what types of fixed-income exposure you want. As with equities, owning a diversified fund or funds can help you weather different segments of the economic cycle. That could mean buying a single, catch-all “core” bond fund, or mixing and matching different types of bond funds chosen for their market exposure, maturity, and risk.

Core bond funds are among the most diversified of bond funds. They can serve as an anchor to a portfolio and often have a “total return” objective, seeking growth through both yield and price appreciation.

Core bond funds hold a mix of sectors, such as U.S. government securities (Treasurys), mortgage-backed securities (MBS), and corporate bonds, focusing on high-quality, investment-grade debt. Holdings often number in the thousands to give investors broad, relatively steady exposure to the bond market.

For investors looking for a simplified portfolio, core bond funds can be their sole choice. As with all investments, buyers should look at each bond fund’s holdings to ensure they agree with their expectations. Because core bond funds focus on investment-grade U.S. debt, they can be considered a building block for investors looking to expand into other areas of the fixed-income world.

High-yield (or “junk”) bond funds hold debt that’s below investment grade—anything with bond ratings from BB to D. The further down the alphabet, the higher the risk for default, which is why investors receive higher yields. A default means the issuer missed payments to bondholders. Most junk bond funds hold hundreds or thousands of bonds so that a single default won’t affect the overall return, but there’s still a risk, especially if defaults rise overall. To be considered a high-yield bond fund, a fund usually holds at least 65% or more of assets rated BB or lower.

A small allocation to high-yield bond funds can boost returns, but it should match up with your tolerance for risk and investment goals. To see if a high-yield fund is right for you, look at both its duration (its sensitivity to changes in interest rates) and credit quality average. Junk bonds with lower durations are less sensitive to rising rates, while the average credit quality shows how risky they are. Check the historical performance and return volatility, because these bond funds tend to have more price swings than other funds.

Index bond funds are perhaps the cheapest way to get diversified exposure to the fixed-income market. Like equity index funds, these products track an established index with the goal of mirroring the return, minus the fees. Because these are passive funds, the manager’s job isn’t to craft an optimal portfolio, but rather to mirror the holdings in the underlying index. As a result, the annual cost to own these funds is often pennies. For example, the iShares Core U.S. Aggregate Bond ETF (AGG), which follows the most widely followed bond index (the Bloomberg Aggregate Bond Index) has an annual expense ratio of 0.03%, or 3 cents for every $1,000 invested.

Although index funds don’t have active managers, it’s still important to understand how the index works and how closely the fund tracks the index return over time. Before you invest in a fund, read the prospectus to find out how index constituents are chosen and how often the index rebalances those holdings.

These funds invest in companies that issue bonds to finance activities such as modernizing, expanding, or investing in other growth areas. Corporate bond funds generally hold investment-grade debt. Investors like corporate bond funds because they typically have higher yields than U.S. Treasury bonds, although they offer lower yields (but also less risk) than high-yield junk bonds.

To be considered a corporate bond fund, these vehicles must hold at least 65% of the fund’s assets in investment-grade corporate debt, which is considered BBB– (or Baa for Moody’s) and above. When looking at a corporate bond fund, review the number of holdings and the fund’s overall credit risk to decide if it’s appropriate for your investment goals. The most popular corporate bond funds hold mostly or nearly all investment-grade U.S. debt, although some corporate bond funds may own a small portion of high-yield corporate bonds or some international company debt.

Again, read the prospectus before investing so you know what you’re buying.

There are two types of bond funds that invest in U.S. government debt: U.S. Treasury bond funds and wider government bond funds. The key difference is that U.S. Treasury bond funds invest only in U.S. Treasury debt, which can range from one-month Treasury notes to 30-year bonds.

The U.S. Treasury market is the deepest and most liquid in the world, making it one of the biggest bond fund markets. Investors can own ultra-short-dated U.S. Treasury funds (those with a year or less to maturity), funds that span the entire Treasury curve, or somewhere in between. U.S. Treasury bond funds are backed by the full faith and credit of the U.S. government, so credit risk is almost nonexistent.

Government bond funds can hold U.S. Treasury debt but also agency debt, such as mortgage-backed securities from Freddie Mac and Fannie Mae, and debt from other government agencies such as the Federal Home Loan Bank, Federal Farm Credit Bank, Tennessee Valley Authority, and others. These funds may have slightly higher yields than U.S. Treasury bonds and carry the same credit rating; however, agency debt is not a direct obligation of the U.S. government (although there is an implicit government backing for agency debt).

Also called muni bond funds, these funds are a way for investors to generate tax-efficient income while investing in projects planned by local governments. The municipal bond fund category is often divided into two subcategories: national muni bond funds and state-specific muni bond funds. Income from muni bond funds is generally free from federal taxes, and for investors who live in high-tax states, there are several state-specific funds they can invest in to receive state tax breaks, too.

Because of their tax advantages, muni bond funds typically earn a lower yield than comparable “taxable” bonds. You might not want munis in a retirement account or other tax-advantaged plan. The value of the tax advantage gets watered down in a tax-free bond, leaving you with a net lower yield.

Most U.S. investors have little exposure to bond holdings outside the United States, but international and global bond funds can offer an extra bit of diversification.

There’s a key difference worth noting: International bond funds don’t hold any U.S. debt, while global bond funds may include some U.S. fixed-income exposure mixed in with bonds from around the world. That matters if you’re trying to juggle asset allocation as you build a diverse portfolio, because adding a global bond fund to your portfolio may inadvertently give you too much U.S. debt exposure.

Generally, these funds mostly focus on developed markets such as Europe, Canada, and Japan, for example, but they may also include some exposure to emerging markets like China, India, or Brazil. Some international bond funds focus solely on emerging markets.

As you research these funds, you’ll quickly find that they can be complex, particularly in how the yields reflect exchange rates between countries. Be sure to review the standard bond fund criteria, but also look at how the index or fund manager selects holdings based on country or region and weights that exposure—and whether the fund hedges out the currency impact. That can affect returns, depending on the U.S. dollar’s strength or weakness.

If your bond fund exposure is limited to a couple of mutual fund choices in a company 401(k) plan, you might consider investing in a core bond fund to feel more confident that you’ve made a step toward diversification.

Alternatively, if you want to channel your inner fund manager, you could scan the universe of fixed-income securities and build your own fund by mixing different types, varying the maturity dates (a strategy called “laddering”), and maybe adding some international exposure.

That’s investing like a pro.