Watch the one-minute video or scroll down to read the full article

 

By: Robert F. Abbott, freelance writer and author

Keeping Safe

Preservation of capital is the most common objective of these funds. As we noted in a previous article, equity mutual funds provide growth, but the greater the expected growth, the greater your exposure to risk.

Bond mutual funds, as the name suggests, are based on bonds and therefore safer than stocks (equities). As a bondholder, or bond mutual fund owner, you loaned money to a government or corporation, and the deal is that they’ll pay you interest regularly and then pay the principal amount when the bond expires. That’s why we have expressions such as 5-year bonds and 20-year donds. Most bonds pay a fixed amount of interest on a monthly or quarterly basis, and the mutual fund passes that interest along to you (less their fees, of course).

This higher degree of safety exists because bond holders own debt (a loan), rather than equity. For example, if the XYZ company goes bankrupt, the debt holders get priority access to whatever is left of the company after its immediate creditors (such as employees and the government) have satisfied their claims. Debt holders get paid in full before the equity (stock) owners get a cent. In fact, you may have heard of cases in which debt holders push a teetering company into bankruptcy to ensure there’s enough remaining money to satisfy their claims.

Relative Safety with Bond Mutual Funds

At the same time, we need to see this safety as relative. First, while most government bonds are safe, we can’t say that of all of them. As a rule of thumb, bonds are only as good as the governments that issue them. As I’m writing this, financial markets are roiled because of potential bond defaults by several European countries, including Portugal, Ireland, Italy, Greece, and Spain (the PIIGS). Similarly, some American states and municipalities find themselves squeezed between increasingly expensive obligations and organized citizen resistance to tax increases.

If a default occurs, bond holders will lose part or all of their principal. Naturally, investors want a higher premium when higher risk exists, so some bold investors are buying PIIGS bonds, while more cautious investors won’t buy them at any price.

Investors also can earn higher rates of interest by buying corporate bonds, which are generally rated as less safe than government bonds. While the company that issued the bond may be very well established, no corporation can count on the power of taxation like government.

The riskiness of bonds also varies with what’s called interest rate risk. If interest rates go up, then the value of a bond goes down. And, when interest rates fall, bond prices go up. And, the longer the bond (the more years until the issuer pays back the principal) the greater the risk.

So, investors consider a 1-year bond safer than 5-year bond, for example. This reflects uncertainty about the future; we have a better idea about what might happen to a government or corporation in the coming year than we do in the next 5 years.

Spreading the Risk

To address this issue, some mutual fund companies offer what are called laddered bond mutual funds. For example, these companies might buy bonds with 1-year, 2-year, 3-year, 4-year, and 5-year expiries. A year later, the maturities will all be one year shorter, and the company will replace the expired 1-year bonds with new 5-year bonds. This is one way of earning some extra premium while still keeping risks within predefined limits.

Generally, mutual funds composed of government bonds or other government guaranteed instruments are quite safe, as will be bonds from established corporations, but always read the fine print in the prospectus just to be sure.

In summary, use bond mutual funds when you want to keep your capital safe, and you’d like to receive regular income from that capital. As we’ve seen, many variations exist and you can likely find a fund that matches your risk/reward profile.

Next, Balanced Mutual Funds

Mutual Fund Fact 4: In 2013, the median number of mutual funds owned by American households was 3 (2014 Investment Company Fact Book)