Diversifying among bond funds
Not all bond funds are created equal — learn the differences to achieve the proper investment mix among your bond investments.
Allocating your portfolio among stock funds and bond funds is just part of the task when it comes to portfolio diversification. While many investors recognize that there are different types of stock funds offering a range of asset classes, risk levels and geographical diversification, too many lump bond investments in one category. That’s a mistake. There is a wide variety of bond funds, each offering varying degrees of risk and return, making it just as important to achieve the proper investment mix among your bond investments as with your stock investments.
U.S. government bond funds invest primarily in U.S. Treasury bonds, government agency obligations and mortgage-backed debt of Ginnie Mae, Fannie Mae and Freddie Mac. Unlike fund shares, Treasury bonds and direct obligations of federal agencies carry a government guarantee. With the exception of Ginnie Mae, mortgage-backed bonds are not government guaranteed. Government bond funds carry the lowest credit risk among bond fund investments; nonetheless, they are subject to interest rate fluctuations, as are all bonds. Some states exempt income from Treasury bonds (but not other types of government bonds) from state and local taxes.
Corporate bond funds come in a wide variety of choices. Some invest primarily in investment-grade bonds (rated BBB and above), which are bonds deemed suitable for most investors by credit rating agencies. Others include a percentage of below-investment-grade bonds (BB and below), which typically feature higher risk and greater potential for income. It’s wise to look closely at that percentage in weighing your investment. There are also high-yield bond funds, which focus entirely on this riskier segment of the market. Besides a possibly higher income return, price appreciation could occur if companies in the portfolio improve their financial condition.
Intermediate-term bond funds steer a middle ground, seeking a higher return than short-term debt offers, but with less price volatility than long-term bonds experience. These funds typically invest in a mixture of government and corporate securities. While these bonds are usually less sensitive to interest rate changes than long-term bonds, they generally offer a lower income stream as well.
Municipal bond funds invest in bonds issued by state and local authorities. In most cases, interest income is free from regular federal taxes. Some funds invest only in the bonds from a single state, and shareholders who are residents of that state may enjoy interest income free from state and local taxes as well. Municipal bond yields may appear lower than yields on comparable taxable bonds, but that is often not the case when tax savings are factored into the equation.
International bond funds invest in the debt securities of non-U.S. companies and governments. If domestic bonds are included, the fund is referred to as a global or world bond fund. These funds allow investors to take advantage of various economic and political conditions around the world, including declines in the U.S. dollar, to earn a potentially higher return than they could with domestic bonds alone. However, they are considered more aggressive than a domestic U.S. bond fund due to the risks inherent in international investing, such as fluctuations in currency exchange rates.