Bonds are perhaps the least understood form of investment, although growing up you might have received a U.S. savings bond as a birthday present or perhaps you remember voting for a local bond issue for a school or park. We thought investors might appreciate a refresher on what bonds are, how individual bonds and bond funds are different, and the role bonds play in a diversified* portfolio.
A bond is simply a loan that the investor makes to the bond issuer when the issuer needs to raise capital (money). Bond investments usually offer a lower return than stocks but are less risky. Like a loan, a bond pays a coupon (interest) at specific intervals and repays the principal amount at the time of maturity. Due to the payout schedule, bonds are also referred to as “fixed-income” investments.
Types of bonds
- U.S. Treasury: The U.S. government issues bonds to raise capital and/or make payments on outstanding debt. Backed by the full faith and credit of the U.S. government, Treasurys are the highest-quality investments because there is little risk of default.
- Agency bonds: This is debt issued by a government-sponsored enterprise (GSE) or a federal agency. GSE obligations are not guaranteed by the government, whereas a federal agency’s debt is backed up by the full faith and credit of the U.S. government. Well-known GSEs include Freddie Mac, Fannie Mae and Ginnie Mae.
- Municipal bonds: To fund the construction of schools, roads and other public projects, state and local governments issue municipal bonds. Since local governments can go bankrupt, this investment type has additional risk but historically has offered a higher rate of return than Treasurys and agency bonds.
- Corporate bonds: Corporations may issue bonds to buy equipment, conduct research and development, and finance acquisitions. These bonds tend to carry a higher level of risk than government bonds but have potential for higher earnings. The value and risk associated with corporate bonds depend in large part on the financial outlook and reputation of the company issuing the bond.
- High-yield bonds: Also called junk bonds, these are bonds issued by companies with low credit quality. To offset the companies’ low credit quality, junk bonds usually offer a higher rate of return than the above bonds to attract investors.
Characteristics of bond funds
A bond fund is a collection of individual bonds. Bond funds are often a more efficient way of investing in bonds than buying individual bonds. Just like equity funds, bond mutual funds pool your money with other investors, and portfolio managers invest that pool of money based on their assessment of the return potential and issuers’ creditworthiness.
The primary goal of a bond fund is to generate monthly income for investors. The investment strategy for each fund is different based on its objective. When evaluating which fund is right for you, it is important to consider the following:
- Average maturity: The average time it will take for the holdings in the fund to mature. Typically, the holdings mature in one to three years for short-term funds, three to 10 years for intermediate-term funds and 10 or more years for long-term investments.
- Duration: An estimate of the fund’s price sensitivity to changes in interest rates. As interest rates rise, bond prices tend to go down. As interest rates fall, the price of bonds tend to go up. Bond funds with shorter average maturities tend to be less sensitive to changes in interest rates, while bond funds with longer average maturities tend to be more sensitive to changes in interest rates. For example, Homestead Funds’ Short-Term Government Securities Fund and Short-Term Bond Fund would generally be less sensitive to changes in interest rates than the Intermediate Bond Fund.
- Credit quality: A measurement of the investments in the fund’s ability to repay its debt, which is an indicator of the potential risk.
- Yield: The return to an investor based on the coupon and maturity cash flows of the investments in the fund.
| Average Maturity | Interest Rate Sensitivity | Credit Quality | Yield | Risk | |
|---|---|---|---|---|---|
| Short-Term Government Securities Fund | Three years or less | Low | High | Low | Low |
| Short-Term Bond Fund | Three years or less | Low | High | Low | Low to Medium |
| Intermediate Bond Fund | 3-10 years | Medium | Medium | Medium | Medium |
Bond yields and prices move in opposite directions
Imagine you purchase a bond with a coupon rate of 5% and a $1,000 face value. The investor will earn $50 a year in interest. Assuming there are no changes to the interest rate environment, the face value of the bond should remain the same at maturity. The coupon rate does not change; that’s what is fixed in a fixed-income security. Because the coupon rate doesn’t change, it is the price of the bond that will reflect any changes in market interest rates.
When interest rates drop: The original bond has become more valuable. Because investors want to benefit from a higher coupon rate, they will pay extra for the bond to tempt the original owner to sell. The increased price will bring the bond’s total yield down for new investors because they will have to pay an amount above face value to purchase the bond.
When interest rates rise: The 5% coupon is no longer attractive; therefore, the bond’s price will start selling for less than face value. The decreased price will bring the bond’s total yield up for new investors because they will have to pay less than face value to purchase the bond.
Why consider investing in bond funds?
Bond funds can be a good option for investors who want an investment potentially more stable than equities. Most bond funds pay a monthly dividend. If the investor prefers not to receive the monthly income, the dividends can be reinvested and go toward the purchase of additional shares.
In terms of risk, bonds tend not to fluctuate as widely in price as stocks; adding bond funds to your portfolio mix can help offset some of the higher levels of volatility equity funds pose.
Bond funds are a good way to diversify your portfolio. The investment minimums for bond funds tend to be low enough that you can get more diversification for much less money than if you purchased individual bonds. Unlike investing in an individual bond holding, bond funds never mature due to the turnover of underlying holdings over time.
Our bond funds
Homestead Funds has a selection of bond funds that can provide diversification and the potential for higher income than money market funds in certain interest rate environments.
*Neither asset allocation nor diversification guarantees a profit or protects against a loss in a declining market. They are methods used to help manage investment risk. Investments in fixed-income funds are subject to interest rate, credit and inflation risk. Interest rate risk is risk that a change in rates will negatively affect the value of the securities in the fund’s portfolio.
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