Choose A Bond Fund For Greater Diversification

Bond funds offer investors an opportunity for diversification and professional management.

Fund performance

Just because a mutual fund company buys bonds, owners of the fund still must accept certain risks. One example is “interest rate risk,” which means that as interest rates rise, bond values fall. Therefore, the money you invest in a bond fund can decrease during periods of rising interest rates in the economy. And the opposite is true, too. If you own a bond fund, and interest rates in the world drop, the bonds inside the fund will appear more attractive on the market and the value of the fund should appreciate. A fund’s sensitivity to fluctuations in interest rates depends upon the duration of its holdings.  Bonds with a longer duration tend to be more volatile than bonds with shorter durations.

Though time frames are not exact, investors generally consider funds as “short-term” if their holdings mature between zero to 3.5 years, “intermediate-term” if they are 3.5 to six years, and “long-term” if they are longer than six years.

Another indicator of a bond fund’s performance is its credit quality. Credit quality is the creditworthiness of the company or entity issuing the bonds as determined by bond rating agencies.

High-yield funds usually involve more risk because they buy low-quality bonds (often called “junk bonds”). High credit-quality bond funds include investment holdings with high average credit values.

Knowing a fund’s duration and credit quality allows you to determine the risk level of your investment.

Diversifying your bond investments

Getting the right mix of bond types is important for achieving a well-rounded investment portfolio. You can achieve this by investing in a combination of government bond funds, mortgage-backed bond funds, corporate bond funds, municipal bond funds, and global bond funds. You do not have to invest in all of these types of funds. The mix that works for you depends upon your investment goals and the amount of risk you are willing to accept.

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Douglas Goldstein, CFP, is an investment advisor and author of Rich As A King: How the Wisdom of Chess Can ...

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