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FEATURE ARTICLE - MAY/JUNE 2005
Bond Funds: 101
Socially responsible bond funds make porfolio diversification easy. Learn more about these investing vehicles and how they can work for you.
Financial planners may be the only people who get excited about bond funds, but there are good reasons to consider these investment vehicles. In general, bonds are less-risky investments than stock purchases but carry more risk than FDIC-insured savings accounts or CDs. What this means is that you can earn a higher rate of return on bond funds than you would on the most conservative bank-insured investments (such as CDs) while shielding yourself from the higher risk of more aggressive investment options. Whether you’re diversifying your retirement portfolio or using investments to generate income, it’s worthwhile to consider bond funds—so read on to learn more about these investment vehicles and how to approach them.
Bond Fund Basics
When companies or government entities want to undertake capital improvements, expansions, or other major projects, they’ll often issue bonds to raise the necessary funds. Bond purchasers are effectively loaning money to the bond issuers, and the bond issuers are agreeing to repay that money within a specified amount of time with a specified rate of interest. The risk comes from the possibility that the bond issuer might be unable to fulfill its obligations to bond holders.
Like all mutual funds, bond funds make multiple investments to mitigate risk—one bond investment may lose money, but other bond investments in the portfolio may make money and allow the portfolio as a whole to perform well. Bond funds will generally focus on bonds from certain types of issuers and with a certain type of term. Bonds can be issued by corporations, federal governments, municipal governments, government agencies, or government-sponsored enterprises. Bond funds may invest in a mix of these types of bonds, depending on their objectives.
US Treasury bonds are considered to be the safest bond investment because, according to conventional wisdom, it’s unlikely that our federal government will collapse and fail to pay off the debts that its bonds represent. Some investors have ethical concerns about Treasury bonds, though; see the “Values” section below for details.
US government agency bonds: US government agencies, such as the Government National Mortgage Association (Ginnie Mae), and government-sponsored agencies, such as the Student Loan Marketing Association (Sallie Mae) and the Federal National Mortgage Association (Fannie Mae), are sponsored by the federal government, though not actually guaranteed by it, so the level of risk association with bonds issued by them is slightly higher. These groups fund loans to certain groups of borrowers, such as home-owners and students, and issue bonds to raise money to loan out.
State, county, and city governments issue municipal bonds to build schools, highways, sewer systems, and other projects that serve their areas. Their bonds are also considered to be fairly safe investments, although again, the risk is slightly higher than it is with US Treasury bonds.
Corporate bonds, which are often issued by companies undertaking expansion or capital improvement, are generally riskier than these other types of bonds, since companies have been known to default on their debt obligations.
Likewise, bonds issued by other countries' national governments have varying levels of risk depending on the likelihood of each country’s government honoring its financial obligations.
Bond issuers also have varying levels of credit-worthiness, and you can check their credit ratings to determine whether or not you feel comfortable taking a risk on them. Credit rating agencies such as Moody’s and Standard & Poors rate companies or government entities based on the likelihood of their defaulting on the interest or principal due on their bonds. The ratings range from a high of AAA to a low of C (with an AAA being one step above an AA, and an A one step above a BBB).
Lower-rated bonds generally offer higher rates of return in exchange for a greater risk of default. Bond funds will invest specifically in high-credit-quality bonds (rated AAA or AA), moderate-credit-quality bonds (rated A or BBB), or high-yield (a.k.a. “junk”) bonds (rated BB or lower).
Type of Term
When buying a bond, it’s important to consider its maturity date—that is, the date when it’ll pay back its lenders. Bond funds generally focus on bonds whose maturity dates fall within a specific time frame: short-term bond funds tend to focus on bonds maturing within the next few years; intermediate-term bond funds on those maturing within seven to ten years; and long-term bond funds on those maturing in 15 to 20 years.
Bond maturity dates are important because interest rates affect bond performance. Longer-term bonds are more volatile because there’s more time for interest-rate fluctuations to affect their profitability. Eric Tyson explains it this way in Mutual Funds For Dummies, 3rd Edition (IDG Books Worldwide, 2004): “Back in the 1960s … companies were issuing long-term bonds that paid approximately four percent interest. At the time, such bonds seemed like a good investment because the cost of living was increasing only two percent a year. But when inflation rocketed to six, eight, and then ten percent and higher, those four percent bonds didn’t look so attractive. The interest and principal didn’t buy nearly the amount it did years earlier when inflation was lower.”
When considering a bond fund, an investor will want to look at its average maturity date. Two different funds might invest in bonds with maturity dates that range from five to 15 years, but one’s average maturity date might be eight years while the other’s is 11 years. Of these two funds, the one with the 11-year average maturity date will be more volatile.
Are Bond Funds for You?
If you’re wondering whether or not you should invest in a bond fund or are trying to figure out what kind of bond fund to invest in, here are some factors to consider.
Investing objectives: As mentioned above, bond funds can be appropriate for investors who want a level of risk that falls somewhere between FDIC-insured bank deposits and stock funds. Tyson recommends viewing them as long-term investment vehicles, because “in the short term, the bond market can bounce every which way; in the longer term, you’re more likely to receive your money back with interest.”
Bond funds also typically pay out monthly dividends, which can be attractive to some investors who want a steady income from at least some of their investments.
Bond fund investments can also be part of a well-diversified portfolio. Bonds don’t behave the same way stocks do, so having shares in bond funds as well as stock funds can balance your risk. Jack Brill, co-founder of Natural Investment Services and co-author of Investing with Your Values: Making Money and Making a Difference (New Society Publishers, 2000), recommends that investors allocate a growing percentage of their portfolios to bonds as they approach retirement age, since overall, bonds are less risky than stocks.
Tax Situation: Interest on US Treasury bonds is free from state tax (though it is federally taxable). Interest from many municipal bonds is federal tax-free, and may be free from state and local taxes as well. In exchange for these tax advantages, these bonds generally offer lower yields. If you’re in a higher tax bracket and are investing outside of a tax-deferred retirement account, the tax-advantaged bonds may give you a higher after-tax yield—so you may want to seek out a bond fund that focuses on tax-exempt investments.
Values: Brill suggests that socially responsible investors avoid US Treasury bonds because “these bonds support the entire debt of the US, which includes the Iraq war, corporate welfare subsidies, and wasteful pork-barrel spending.”
Instead, he recommends that investors seeking a taxable bond investment choose bonds issued by government agencies such as Ginne Mae. Tax-free municipal bonds—which support public schools, transit systems, and local community infrastructure—are a good choice as well. These are available as individual investments or in bond funds that focus on these types of investments. (Brill notes that some municipal bonds may include funded projects, such as prison construction, that may be objectionable to social investors, but that these investments are likely to be only a small percentage of the holdings.)
Brill also notes that socially responsible investing (SRI) bond funds can be a good option for social investors. These funds will generally apply the same kinds of screens to bond funds as they do to their other SRI mutual funds, and they may also engage in shareholder advocacy or seek to invest in positive projects. Justin Conway, Green America’s community investing coordinator, says, “SRI bond funds have helped direct more money to projects that build strong communities by investing in securities targeting low-income individuals or in the community investment institutions that advance economic development.”
It’s always a good idea to consult a financial planner when starting new investments; if you don’t already have a planner, you can find one in Green America’s National Green Pages™ (also available as print copy for $11.95 by calling 800/58-GREEN).
You can also learn more about a specific bond fund by requesting a prospectus from its investor relations department or visiting its Web site. When weighing one bond fund against another, remember that comparing funds whose bonds have different average maturities is like comparing apples to oranges. Even if two bond funds both fall into the short-term category, one might have an average maturity of two years while another has an average maturity of five years, and the three-year gap will mean a difference in interest rates and risk. You’ll also want to look at funds’ operating expenses.
So, the next time someone mentions bond funds, don’t let your eyes glaze over. Instead, remember that these investments have an important role to play in diversifying portfolios and balancing financial risk and rewards.
SRI Bond Funds